the option course with exercise.pdf

TheOptionsCourse

Workbook

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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Aus-tralia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.

The Wiley Trading series features books by traders who have survivedthe market’s ever changing temperament and have prospered—some byreinventing systems, others by getting back to basics. Whether a novicetrader, professional, or somewhere in-between, these books will providethe advice and strategies needed to prosper today and well into the future.

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TheOptionsCourse

WorkbookSecond Edition

Step-by-Step Exercises and

Tests to Help You Master

The Options Course

GEORGE A. FONTANILLS

John Wiley & Sons, Inc.

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Copyright © 2005 by George A. Fontanills and Richard Cawood. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty maybe created or extended by sales representatives or written sales materials. The advice andstrategies contained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any lossof profit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

For general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outsidethe United States at 317-572-3993 or fax 317-572-4002.

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ISBN 0-471-69421-5

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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www.wiley.com

To our global community

that we may strive to create

a peaceful world

for all our children.

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Contents

CHAPTER 1 Options Trading: A Primer 1

CHAPTER 2 The Big Picture 9

CHAPTER 3 Option Basics 31

CHAPTER 4 Basic Trading Strategies 53

CHAPTER 5 Introducing Vertical Spreads 67

CHAPTER 6 Demystifying Delta 79

CHAPTER 7 The Other Greeks 87

CHAPTER 8 Straddles, Strangles, and Synthetics 100

CHAPTER 9 Advanced Delta Neutral Strategies 116

CHAPTER 10 Trading Techniques for Range-Bound Markets 129

CHAPTER 11 Increasing Your Profits with Adjustments 141

CHAPTER 12 Choosing the Right Broker 149

CHAPTER 13 Processing Your Trade 159

CHAPTER 14 Margin and Risk 170

CHAPTER 15 A Short Course in Economic Analyses 181

vii

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CHAPTER 16 Mastering the Market 188

CHAPTER 17 How to Spot Explosive Opportunities 194

CHAPTER 18 Tools of the Trade 212

CHAPTER 19 Final Summary 218

viii CONTENTS

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TheOptionsCourse

Workbook

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CHAPTER 1

OptionsTrading:A Primer

SUMMARY

Starting to trade options can be stressful and unsettling, but it doesn’t haveto be. By learning to trade options systematically and by fostering a patientapproach, a new trader can become successful. Options trading requiresan understanding of the characteristics of options and this takes time tomaster. Nonetheless, a person who is willing to study and work hard canachieve success.

To become successful at trading options, you need to focus on threeimportant features of options: duration, direction, and magnitude. If un-derstood, the interrelation of these three issues can provide the edgeneeded to win at options trading. There are, however, some stepping-stones that need to be put in place before jumping headlong into the op-tions game. Following the suggestions in this book will enable you togain the knowledge and skills necessary to trade profitably. Mainly, anew trader should start small, not placing too much capital in any onetrade initially. New traders should also paper trade strategies to get abetter feel for how each strategy works. Any trader, new or experi-enced, should define the risk before entering any trade. Only consistentrisk managers make it in the trading profession; so do your homeworkand follow the steps outlined in this book.

1

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QUESTIONS AND EXERCISES

1. True or False: Just because someone is licensed to place a trade doesnot mean the person has the knowledge to invest your money wisely.

2. What is the difference between an investor and a trader?

____________________________________________________________

____________________________________________________________

____________________________________________________________

3. Successful options traders use only ________________ that are read-ily available and can be invested in a sound manner.

A. Options.

B. Funds.

C. Futures.

D. Stocks.

4. It is critical to accurately assess your ______________ to determinethe style of investing that suits you best.

A. Flexibility.

B. Interest.

C. Markets.

D. Time constraints.

5. How can you minimize your losses when you first begin trading options?

A. Start small.

B. Learn to paper trade.

C. Interview several brokers before picking the one most suited toyour needs.

D. All of the above.

6. What is the most important factor for building a low-stress invest-ment strategy?

A. Understanding your markets.

B. Having a good broker.

C. Defining your risk in every trade.

D. Learning to paper trade first.

2 THE OPTIONS COURSE WORKBOOK


7. ______________ allows a trader to cultivate a matrix of strategieswith which to respond to market movement in any direction.

A. Flexibility.

B. Specializing.

C. Computer access.

D. Confidence.

8. Successful investors usually ______________ in just one or in a fewareas. This allows them to develop strategies that work in certainrecognizable market conditions.

A. Specialize.

B. Win.

C. Go short.

D. Systematically invest.

9. To become a successful options trader you have to have______________.

A. Lots of money to invest.

B. Patience and persistence.

C. A computer.

D. A good sense of market direction.

MEDIA ASSIGNMENT

The Internet is a great resource for new and experienced traders. Not onlycan traders place trades online, but there is a plethora of free options in-formation that can be easily accessed. For example, the Optionetics website has a wide range of information and numerous articles that can fosterprofitable trading for both new and experienced traders. Take the time tobecome familiar with the Optionetics site in order to benefit from thetools and information found there. This is also a great starting point tofind a broker. The site offers a section dedicated to providing in-depthinformation about the various options brokers out there. Take the time toreview this information so you’ll be prepared to open a brokerage accountwhen the time comes.

Options Trading: A Primer 3


VOCABULARY LIST

SOLUTIONS

1. True or False: Just because someone is licensed to place a trade doesnot mean the person has the knowledge to invest your money wisely.

Answer: True.

Discussion: Unfortunately, obtaining a license to place a trade doesnot necessarily make someone a good trader. Like many things in life,sometimes book knowledge isn’t enough to create success. Whenlearning to drive a car, someone doesn’t just immediately move outonto the freeway after reading a book. Though having a license doesteach some important things, it isn’t a guarantee that the person willbe successful at trading.

2. What is the difference between an investor and a trader?

Answer: An investor takes a long-term, passive approach. A tradertakes a more active approach using various options strategies thattend to capitalize on shorter-term market movement.

Discussion: As the term implies, an investor is investing his/hermoney into a company by buying stock in it. A trader isn’t necessarilyconcerned with ownership, just profits and short-term gains. Most in-vestors are people who buy and hold stock or mutual funds; they aremore in step with the Warren Buffett approach to long-term security.A trader seeks profits in the short term, trading stocks and options


Bear

Broker

Bull

Call

Capital

Delta neutral

Go long

Go short

Investor

Leverage

Paper trading

Put

Return

Risk

Risk management

Stop loss

Trader


with a clear eye on risk management and a friendly ear for volatility.Undoubtedly there are many who dabble somewhere in between.

3. Successful options traders use only ______________ that are readilyavailable and can be invested in a sound manner.

Answer: B—Funds.

Discussion: Though Optionetics teaches traders how to use optionsto limit risk, there still is a chance that the capital used in trading op-tions could all be lost. As a result, it is wise to only use money that isnot needed for bills or other important necessities in life. If you tradeusing capital you cannot afford to lose, it is very difficult to tradewithout letting your emotions get in the way.

4. It is critical to accurately assess your ______________ to determinethe style of investing that suits you best.

Answer: D—Time constraints.

Discussion: If the capital you plan on using to trade options is alsoneeded for an important life event in the next year or two, it is unwiseto use it. Though quick profits can often be made trading options, westill need to trade with a long-term goal in mind. Even a successfuloptions trader might go through a losing streak, and if the capital isneeded during this down time, it can be a difficult situation.

5. How can you minimize your losses when you first begin trading options?

Answer: D—All of the above (start small, learn to paper trade, inter-view several brokers before picking the one most suited to yourneeds).

Discussion: All of these issues should be used when first starting totrade options. The nice thing about options is that it doesn’t take ahuge amount of capital to get started. Nonetheless, even if you have anice nest egg to begin with, start small. Try to learn how the strategieswork before taking a bigger leap. You may want to paper trade a newstrategy so you won’t lose capital during the learning process. Evenso, there eventually comes a time when the trader will not be able tolearn more until he or she trades with real capital. Using a brokerwho gets a trade a good fill and is easy to work with is crucial for thelong-term success of an options trader. With the number of brokersavailable, don’t be afraid to change brokers if the one you start withisn’t working out.



6. What is the most important factor for building a low-stress invest-ment strategy?

Answer: C—Defining your risk in every trade.

Discussion: Those who pay attention to Optionetics instructors andwriters will hear this all the time. Options were first developed tohelp traders limit risk, and Optionetics still believes this is the key.We need to know the risk of every trade before we enter it so that weare prepared for the worst and know what actions are needed to limitthis risk.

7. ______________ allows a trader to cultivate a matrix of strategieswith which to respond to market movement in any direction.

Answer: A—Flexibility.

Discussion: Though it is a good idea to narrow your choice of strate-gies, this doesn’t mean that a trader shouldn’t have a couple of strate-gies for each type of market. One of the greatest advantages totrading options is their flexibility. You can make money in up, down,and sideways markets using options, so don’t limit yourself to justbullish strategies.

8. Successful investors usually ______________ in just one or in a fewareas. This allows them to develop strategies that work in certainrecognizable market conditions.

Answer: A—Specialize.

Discussion: Specialization has become the thing to do in any profes-sion in our day and age. It is no different when trading options.Though we need to have a wide base of knowledge about options andtrading, we do not need to become experts in every available optionsstrategy. As you learn about different options strategies, specialize inthe ones that best fit your risk tolerance and expertise.

9. To become a successful options trader you have to have______________.

Answer: B—Patience and persistence.

Discussion: This is very important to remember. Too many newtraders expect to become millionaires overnight; this is unrealistic.Traders need to realize that where there is more possible reward,there is usually a higher degree of risk. Even the most successful op-tions traders often lose money in individual trades. However, thesetraders have learned to limit their risk and have developed a soundplan that allows them to be patient and persistent.



MEDIA ASSIGNMENT

Learning to use the Internet to further your understanding of the marketand options is a vital part of your trading education. The free Optionet-ics web site has a plethora of information. Mainly, take the time tosearch for information dealing with the initial strategies you want tomaster. As you progress up the learning curve, read the daily articles togain an understanding of the markets. You can also read about variousoptions brokers on the Brokers Review link. This will provide informa-tion about costs, services, and other important data about most of theoptions brokers available.

VOCABULARY DEFINITIONS

Bear: An investor who believes that a security or the market is falling oris expected to fall.

Broker: An individual or firm that charges a fee or commission for executing buy and sell orders submitted by another individual or firm.

Bull: An investor who believes that a security or the market is rising or isexpected to rise.

Call: An option contract that gives the holder the right, but not the obliga-tion, to buy a specified amount of an underlying security at a specified pricewithin a specified time (e.g., if you buy an IBM January 85 call, you have theright to buy 100 shares of IBM at $85 each by the third Friday in January).

Capital: The amount of money you have invested. When your investingobjective is capital preservation, your priority is to try not to lose anymoney. When your objective is capital growth, your priority is to try to make your initial investment grow in value. Capital also refers to ac-cumulated money or goods available for use in producing more moneyor goods.

Delta neutral: Refers to an options position constructed so that the prof-itability of the position relies on the magnitude of the move—not the di-rectional bias; it is relatively insensitive to the price movement of theunderlying instruments. A delta neutral trade is arranged by selecting acalculated ratio of short and long positions with a combined delta of zero.

Go long: To buy securities, options, or futures with the intent to profitfrom a rise in the price of the assets.

Go short: To sell securities, options, or futures with the intent to profitfrom a drop in the price of the assets.



Investor: A person whose principal concern in the purchase of a secu-rity is the minimizing of long-term risk, compared to the speculator whois prepared to accept calculated risk in the hope of making better-than-average profits, or the gambler who is prepared to take even greaterrisks. More generally, it refers to people who invest money in invest-ment products.

Leverage: Enables a trader to buy or sell a security or derivative and re-ceive fair value for it using borrowed capital to increase investment return.

Paper trading: Simulating a trade without actually putting up the money,usually done for the purpose of gaining additional trading experience.

Put: An option contract that gives the owner the right, but not the obliga-tion, to sell a specified amount of an underlying security at a specifiedprice within a specified time.

Return: The income earned or a capital gain made on an investment.

Risk: The potential financial loss inherent in an investment.

Risk management: The process of managing trades by hedging risk.

Stop-loss order: An order to sell when the price of the stock declines to,or below, a stated price. The purpose of this is to reduce the amount ofloss that might occur.

Trader: Someone who buys and sells frequently with the objective ofshort-term profit.



CHAPTER 2

TheBig

Picture

SUMMARY

Trading stocks might be the best-known form of playing the markets, butmany individuals specialize in other lesser-known trading instruments.This chapter is designed to give the novice trader a comprehensive view oftrading by exploring the wide variety of different trading instruments—in-cluding stocks, futures, and options—as well as the multitude of ways totrade them. Particular attention is devoted to trading instrument proper-ties as well as specific examples.

Options are derivatives, meaning they derive their value from an un-derlying financial instrument. Though options can be entered using stockas the underlying security, indexes and futures also have options available.Futures and options can be used together, but they are two distinctly dif-ferent instruments and require totally different types of trading accounts.However, both of these instruments provide increased leverage, whichmeans a trader can control a large amount of stock or other instrumentwith little initial capital outlay.

Options are an extremely versatile instrument and can be used to cre-ate a variety of different limited risk strategies. However, like most en-deavors, they require practice and discipline, as well as proper money andrisk management. In addition, traders must pay significant attention tovolatility issues if options are to be successfully utilized. Both historicaland implied volatility are important concepts to understand and should bestudied in depth to master the options trading game.

9



1. A stock is a unit of ownership in a company. The value of that unit ofownership is based on a number of factors, including:

____________________________________________________________

____________________________________________________________

2. Six people form a company together and decide that there will beonly six shareholders with only one share each. If this company’s as-sets total $90,000 and it has $15,000 in liabilities, how much is eachshare worth?

A. $15,000.

B. $12,500.

C. $10,000.

D. $7,500.

3. The computerized market, ______________, is also referred to as theover-the-counter (OTC) market.

A. Securities and Exchange Commission.

B. Chicago Board Options Exchange.

C. Nasdaq.

D. FOREX.

4. Supply and demand for a company’s shares helps to create______________.

A. Momentum.

B. Historical volatility.

C. Liquidity.

D. Time decay.

5. If investors feel a company will beat Wall Street expectations, thenthe price of the shares will be ______________ as there will be morebuyers than sellers.

A. Higher.

B. Lower.

C. Bid up.

D. Offer down.



6. If the majority of investors feel that the company’s earnings willdisappoint the Street, then the prices will be ______________.

A. Higher.

B. Lower.

C. Bid up.

D. Offer down.

7. If there are more bidders (buyers), prices will ______________. Ifthere are more people offering (sellers), prices will ______________.

A. Fall. Rise.

B. Rise. Fall.

C. Stay the same.

D. Be impossible to predict.

8. A company’s board of directors decides whether to declare______________ from time to time to be paid out and distributed toshareholders on a payable date.

A. Better than expected earnings.

B. Revised expected earnings.

C. Cash flow.

D. A dividend.

9. What are the four unofficial size classifications of stocks?

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

4. _________________________________________________________

10. The ______________, which reports the performance of 30 majorcompanies representing key industries, is the most widely quotedindicator of market performance.

A. Standard & Poor’s Index.

B. Amex Market Value Index.

C. New York Stock Exchange Composite Index.

D. Dow Jones Industrial Average.

The Big Picture 11


11. Name a few stock sectors.

____________________________________________________________

____________________________________________________________

12. What is the difference between a futures contract and an optionscontract?

____________________________________________________________

____________________________________________________________

13. ______________ were initially used by farmers and producers ofproducts to hedge themselves or lock in prices for a certain crop orproduct cycle.

A. Options contracts.

B. Futures contracts.

C. Stock contracts.


14. True or False: Hedgers use futures trading to lock in prices andprotect themselves from market movement because they are pri-marily interested in actually receiving or selling the commoditiesthemselves.

15. ______________ do not expect to take delivery of a product; they arein the futures market to try to make money on the price movement ofa futures contract.

A. Producers.

B. Speculators.

C. Hedgers.

D. Farmers.

16. If you believe soybean prices will rise over the next three months,based on whatever information you may have, you could __________the corn futures three months out hoping to make a profit.

A. Go long.

B. Go short.

C. Hedge.




17. If you believe corn prices will fall during this same period, youcould ______________ the corn futures contract three months outhoping to make a profit.

A. Go long.

B. Go short.

C. Hedge.


18. Physical commodities are any bulk good traded on an exchange or inthe cash market; examples include grains, meats, metals, and ener-gies. _________________ include debt instruments (such as bonds),currencies, and indexes.

A. Index futures.

B. ETFs.

C. Financial commodities.

D. HOLDRS.

19. The value of ______________ primarily depends on interest rates.

A. Bonds.

B. Debt instruments.

C. Eurodollars.


20. Typically, there is an inverse relationship between ______________and most foreign currencies.

A. The U.S. dollar.

B. Interest rates.

C. Bonds.


21. A/an ______________ is an indicator that is used to measure andreport value changes in a specific group of stocks, commodities, ordifferent sectors of the marketplace.

A. Bond.

B. Moving average.

C. Index.


The Big Picture 13


22. By combining futures with ______________, you can create trades inwhich you limit your risk and maximize your potential profits.

A. Options.

B. HOLDRS.

C. Futures contracts.


23. ______________ are contracts between two parties that convey tothe buyer a right, but not an obligation, to buy or sell a specificcommodity or stock at a specific price within a specific time periodfor a premium.

A. Stocks.

B. Futures.

C. Options.


24. The price of an option is referred to as the ______________.

A. Premium.

B. Strike price.

C. Bid-ask price.

D. Price-earnings (P/E) ratio.

25. The ______________ is defined as the price at which the stock orcommodity underlying a call or put option can be purchased or soldover the specified period.

A. Premium.

B. Strike price.

C. Bid-ask price.

D. Price-earnings (P/E) ratio.

26. An option is no longer valid after its ______________.

A. Payable date.

B. Expiration date.

C. Exercise date.

D. Assignment date.

27. True or False: Options are available on all stocks.



28. Each stock option (call or put) represents ______________ shares ofa stock.

A. 50.

B. 100.

C. 500.

D. 1,000.

29. True or False: Each futures contract has a set of unique specifi-cations.

30. You must be cautious trading indexes, for a few of them do not havemuch ______________.

A. Diversification.

B. Liquidity.

C. Cash value.

D. Flexibility.

31. The most important factors for determining opportunity in a marketare ______________.

A. Volume and cash flow.

B. Volatility and cash flow.

C. Liquidity and cash flow.

D. Liquidity and volatility.

32. ______________ gives you the opportunity to move in and out of amarket with ease.

A. Volatility.

B. Flexibility.

C. An inexpensive option.

D. Liquidity.

33. ______________ measures the amount by which an underlying isexpected to fluctuate in a given period of time.

A. Volatility.

B. Delta.

C. Theta.

D. Liquidity.

The Big Picture 15


MEDIA ASSIGNMENT

There are numerous indexes and ETFs available for the options trader.This chapter provided examples of many of these securities, as well as anintroductory discussion of volatility. Take the time to look at daily andweekly price charts of various indexes and ETFs as well as their respec-tive volatility levels. When we look at past movement, we are seeing his-torical volatility. However, by looking at a chart, we can also becomepretty good judges of what type of volatility is going to occur in the future.Use a charting program or the Optionetics web site to eyeball these in-dexes and ETFs to see which are the most and least volatile. Learninghow to view charts and access the plethora of information that is availabletakes time, so start by viewing the list of ETFs and indexes listed in thischapter of the main book.

VOCABULARY LIST

SOLUTIONS

1. A stock is a unit of ownership in a company. The value of that unit ofownership is based on a number of factors, including:

Answer: The total number of outstanding shares; the value of the equity of the company (what it owns less what it owes); the earnings the company produces now and is expected


Assets

Assignment

Bond

Capital gain

Commodity

Dividend

Exchange-traded fund (ETF)

Exercise

Futures

Hedgers

Historic volatility

Implied volatility

Liability

Liquidity

Option premium

Payable date

Speculator

Stock

Strike price


to produce in the future; and the demand for the shares of the company.

Discussion: Stock ownership is a way to participate in the growth ofa company. It has limited liability, yet many millionaires have beencreated by their stock ownership. Fundamental analysis can helpbuy-and-hold investors find appropriate long-term stocks to own.However, short-term traders normally focus more on technical indi-cators that include price and volume and supply and demand issues.

2. Six people form a company together and decide that there will beonly six shareholders with only one share each. If this company’s as-sets total $90,000 and it has $15,000 in liabilities, how much is eachshare worth?

Answer: B—$12,500.

Discussion: Because the balance sheet says the company is worth$75,000, each one of the six shares would be worth $12,500 ($75,000 ÷6 = $12,500). This is called book value, but book value is rarely what astock trades for in the stock market. Traders are buying future earn-ings, and this demand normally increases the stock price well aboveits book value.

3. The computerized market, ______________, is also referred to as theover-the-counter (OTC) market.

Answer: C—Nasdaq.

Discussion: The Nasdaq is a computerized marketplace, with buyersand sellers brought together through a computer system. Supportersof the Nasdaq believe this is a much more efficient way to exchangethe buying and selling of shares. Whether this is true or not, the Nas-daq trades more volume on a daily basis than the New York Stock Ex-change (NYSE). The Nasdaq is best-known for being a tech-ladenindex. This is because smaller technology companies have been ableto get listed on the Nasdaq more easily than on the NYSE.

4. Supply and demand for a company’s shares helps to create______________.

Answer: C—Liquidity.

Discussion: Liquidity is important in the options market, as it helpslessen the spread between the bid and ask prices. It would be impos-sible to sell an option that is being held if there weren’t someone tobuy it from you. Market makers are there to help alleviate this prob-lem, but illiquid stocks and options are still difficult to trade and are

The Big Picture 17


best left alone. In general, we don’t want to mess with stocks thathave a volume of less than 300,000 shares a day.

5. If investors feel a company will beat Wall Street expectations, thenthe price of the shares will be ______________ as there will be morebuyers than sellers.

Answer: C—Bid up.

Discussion: The basic economic rule of supply and demand is useddaily in the stock market. When there is an abundance of buyers, thispushes the price higher until the stock price finds an equilibriumpoint. When there are more sellers than buyers, the stock price willfall until equilibrium is found to the downside. This is the definition ofthe free market system and has worked well for centuries. The stockmarket is a great discounter of news, which means expectationsdrive stock prices. Once an event takes place, the stock trades onwhat the expectations were more than the actual results.

6. If the majority of investors feel that the company’s earnings willdisappoint the Street, then the prices will be ______________.

Answer: D—Offer down.

Discussion: Sometimes a stock will gain ground when announcedearnings are not good. This happens because expectations were evenworse than the actual news. When a stock disappoints, though, ittends to see its stock price offered down as traders jump in to sell onthe negative announcement. Sometimes a stock will announce fantas-tic earnings, but expectations were even higher, so the stock still seesa decline after the announcement.

7. If there are more bidders (buyers), prices will ______________. If there are more people offering (sellers), prices will______________.

Answer: B—Rise. Fall.

Discussion: The price of an investment will react to the forces ofsupply and demand. If there are more buyers than sellers within themarket, and demand is strong, prices move higher. However, wheninvestors are selling and supply is rising, prices tend to fall.

8. A company’s board of directors decides whether to declare______________ from time to time to be paid out and distributed toshareholders on a payable date.

Answer: D—A dividend.



Discussion: A dividend is a part of a company’s profit that is passedon to the shareholders. When companies pay part of their profits toshareholders, those profits are called dividends. This amount is an-nounced before it is paid and is distributed to shareholders of recordon a per share basis. The board of directors must declare all divi-dends. Growth companies usually do not offer dividends, as theboard of directors feels the capital is best put to work by investing itback into the company. Utility stocks and other slow moving stockstend to offer the highest dividends. The dividend yield is figured bytaking the amount of the dividend on an annualized basis and divid-ing it by the stock price.

9. What are the four unofficial size classifications of stocks?

Answer: Large caps (blue chips), mid-caps, small caps, and micro-caps.

Discussion: Large-cap stocks represent companies with a capital-ization of more than $5 billion. Also commonly referred to as bluechips, large caps are generally mature companies that are regardedas safe investments. They are traded on the major exchanges andprovide regular dividends to shareholders—perhaps their most ap-pealing advantage. Mid-cap companies have a market capitalizationof between $500 million and $5 billion. Mid-caps typically experienceslower growth than small caps and faster growth than large caps.Small caps have a market capitalization of between $150 million and$500 million. They offer traders the opportunity for fast growth andare usually much cheaper than mid-caps or blue-chip stocks. Lowerprices give them the ability to generate dramatic price gains. Micro-cap stocks have a market capitalization of less than $150 million.They can be extremely risky investments because a significant per-centage of companies fail early in the development cycle for a vari-ety of reasons including poor management, defective marketingstrategy, or customer rejection of goods or services offered. Each ofthe four stock size classifications comes with a unique set of invest-ing objectives.

10. The ______________, which reports the performance of 30 majorcompanies representing key industries, is the most widely quotedindicator of market performance.

Answer: D—Dow Jones Industrial Average.

Discussion: The Dow Jones Industrial Average (DJIA or Dow) is stillthe quintessential barometer of stock market performance and isquoted daily on the evening news. While the DJIA has evolvedthrough the years, the information derived from it is essentially the

The Big Picture 19


same. It gauges the stock prices of 30 U.S. companies and reflects de-velopments within the U.S. economy. The Dow is a price-weighted in-dex in that the average prices of all 30 components are addedtogether and one final average is computed. Though not the best rep-resentative of the broad stock market, the Dow is the most popularindex because it has been around the longest. However, though thereare just 30 stocks represented, this index mirrors the broader marketon a pretty consistent basis. There are times, though, that the Nasdaqand Dow will diverge, and these are important indicators for techni-cal analysts.

11. Name a few stock sectors.

Answer: Technologies, defense, retail, health care, financials, consumer products.

Discussion: There are dozens of different sectors and many subsec-tors. At times a new sector will be created, like Internet stocks. Ana-lysts track various sectors to get a feel for what stocks are bullish andbearish. Not all sectors move in tandem, and analysts can often findleading indicators for the stock market as a whole by studying indi-vidual sectors. There are many exchange-traded funds (ETFs) and in-dexes that track individual sectors, and many of these are optionable.This allows a trader to choose a direction for an entire sector, ratherthan just one stock within the group.

12. What is the difference between a futures contract and an optionscontract?

Answer: A futures contract is a promise to actually deliver or takedelivery of the underlying commodity. In contrast, the purchase of anoption provides the right, but not the obligation, to buy (call) or sell(put) the underlying instrument.

Discussion: Both futures and options can be used to make signifi-cant profits. Futures tend to be employed after a trader becomes fa-miliar with options, but not always. Futures often are consideredmore complicated, but they really aren’t; they are just less under-stood. Many options traders use futures as the underlying instrumentfor their trades. The purchase of a futures contract comes with theobligation to receive delivery of the commodity, bond, or other instru-ment by a specific date. The sale of a futures contract comes with theobligation to deliver the commodity, bond, or other financial instru-ment to the buyer by a certain date. The purchase of an option pro-vides the right, but not an obligation, to buy (in the case of a call) orsell (for a put) the underlying asset.



13. ______________ were initially used by farmers and producers ofproducts to hedge themselves or lock in prices for a certain crop orproduct cycle.

Answer: B—Futures contracts.

Discussion: Individuals or corporations can use futures to get a cer-tain price for a commodity. Farmers use futures to lock in the price ofcorn or wheat a year in advance, which makes it easier to run theirfarms. However, the vast majority of futures traders are now specula-tors who have no interest in making or taking delivery of a product—they are just trying to profit from a directional move in the underlyinginstrument.

14. True or False: Hedgers use futures trading to lock in prices and pro-tect themselves from market movement because they are primarily in-terested in actually receiving or selling the commodities themselves.

Answer: True.

Discussion: A hedger is an investor who uses the futures market tominimize the risk in his or her business. Hedgers may be manufactur-ers, portfolio managers, bankers, farmers, or others. For example, anoil company can sell its product with a futures contract before it isactually produced and ready for sale. By purchasing a futures con-tract, the oil company can lock in the prices of oil at a certain point toguarantee the price it will receive.

15. _____________ do not expect to take delivery of a product; they are inthe futures market to try to make money on the price movement of afutures contract.

Answer: B—Speculators.

Discussion: Unlike hedgers, speculators are using futures to makeprofits, not limit their risk. In fact, these two types of futures tradersneed each other. Hedgers use futures to limit risk, while speculatorsuse risk to make large profits. The two have a symbiotic relationshipthat is necessary to keep the futures market working.

16. If you believe soybean prices will rise over the next three months,based on whatever information you may have, you could______________ the corn futures three months out hoping to makea profit.

Answer: A—Go long.

Discussion: Futures work just like stocks or call options; we wantthe underlying to rise when we buy a futures contract. Of course, like

The Big Picture 21


the stock market in general, futures will be priced based on the ex-pectations for the commodity. If everyone expects it to be a toughwinter, then orange futures might drop in value. However, if you spec-ulate that the winter won’t be as bad as expected, you would benefitfrom buying a future if your belief turns into reality.

17. If you believe corn prices will fall during this same period, you could______________ the corn futures contract three months out hoping tomake a profit.

Answer: B—Go short.

Discussion: Going short involves selling a futures contract; this isvery risky, akin to shorting stock. However, for experienced traders,shorting a futures contract might make sense. Normally, if we want toparticipate in the down movement of a commodity or stock, we arebest served by buying puts. This strategy limits the position’s risk, butstill provides ample profit opportunities.

18. Physical commodities are any bulk good traded on an exchange or inthe cash market; examples include grains, meats, metals, and ener-gies. ______________ include debt instruments (such as bonds), cur-rencies, and indexes.

Answer: C—Financial commodities.

Discussion: Financial commodities have become increasingly popu-lar with options traders. A futures contract of a financial commodityis an obligation to buy or sell a specific quantity of currency or someother financial instrument for a predetermined price by a designateddate. Like any futures, those based on financial commodities aremostly used by speculators, though there are some hedgers who usethem to hedge other holdings. By using options, traders can hedge therisk that comes with the purchase (or sale) of a financial commodity.Other physical commodities include the raw materials used in mostretail and manufactured products. The five major categories aregrains, metals, energies, raw foods, and meats. Some are seasonal innature (heating oil, for instance), which causes demand to fluctuatebased on the time of year and climactic conditions. Others react tospecific events; a drought in the Midwest can send grain pricessoaring. Commodities are also highly leveraged investments. A smallamount of cash can control many times its face value in commoditiescontracts. But this works both ways, creating huge potential wins andlosses. Futures are used by farmers and holders to hedge prices inthe future, but futures on physical commodities still have plenty of



speculators as well. The Chicago Board of Trade (CBOT) is the majorexchange for these commodities.

19. The value of ______________ primarily depends on interest rates.

Answer: D—All of the above (bonds, debt instruments, Eurodollars).

Discussion: All of these commodities depend on interest rates.For example, when interest rates go up, bond (loan) prices fall.Conversely, when interest rates fall below the interest rate guaran-teed on a specific bond, that bond increases in value. Since interestrates can change the value of these instruments drastically, holdersof these instruments will hedge their risk by using options andfutures on interest rates and individual commodities like bonds orcurrencies.

20. Typically, there is an inverse relationship between ______________and most foreign currencies.

Answer: A—The U.S. dollar.

Discussion: Money is greatly affected by international rates of ex-change. The value of a country’s currency fluctuates in relation tovalues of foreign currencies. An inverse relationship usually existsbetween the dollar and other currencies. If the dollar falls, foreigncurrencies may increase in value. For example, if the U.S. dollar isweak in comparison to the yen, the prices of Japanese products im-ported to the United States will increase. If the dollar is high in com-parison to the euro, the prices of American products exported toEurope will rise. An inverse relationship is created because of thelarge amount of imports and exports that the United States partici-pates in. Currencies are traded by large financial institutions lookingfor the best rate of exchange. Since a change in the exchange ratecan create such a huge variance for multinational firms, many ofthese corporations use futures to hedge their risk. Of course, thosetraders who have a strong understanding of foreign currencies canalso speculate on future changes in the value of the dollar as opposedto other currencies.

21. A/an ______________ is an indicator that is used to measure andreport value changes in a specific group of stocks, commodities, ordifferent sectors of the marketplace.

Answer: C—Index.

Discussion: An index is a select group of stocks that measures andreports value changes to the group as a whole. A variety of indexes

The Big Picture 23


are tailored to reflect the performance of many different sectors ofthe marketplace, such as the S&P 500 ($SPX) or the New York StockExchange Composite Index ($NYA). While these indexes are used togauge trends within the stock market, some indexes are designed tomeasure the price changes of specific industry groups. Indexes havebecome increasingly popular over the past 20 years, partly due to theincreased volume of shares traded on the exchanges and the ease ofcreating an index with the proliferation of computers. Regardless ofwhy there are so many indexes, their use has become widespread.Most major exchanges have options and futures available on them, al-lowing a knowledgeable trader plenty of opportunities to hedge riskand make large profits.

22. By combining futures with ______________, you can create trades inwhich you limit your risk and maximize your potential profits.

Answer: A—Options.

Discussion: Options are the perfect trading instrument for leveragingyour capital and hedging stocks and futures against risk. They act toprotect your investments just as buying insurance would for your caror home. Many of us probably could have done a better job “insuring”our portfolios against losses, but only hindsight is 20/20. To be suc-cessful in today’s markets, you need to evaluate your current positionsto see what you can do to be more successful moving forward.

23. ______________ are contracts between two parties that convey to thebuyer a right, but not an obligation, to buy or sell a specific commod-ity or stock at a specific price within a specific time period for a pre-mium.

Answer: C—Options.

Discussion: The key to this definition is that the buyer has the right,but not the obligation, to buy or sell the underlying asset by a certaintime. This varies from a futures contract where there is an obligation.Options are unique and very versatile instruments that can be used tohedge risk and make substantial profits. However, like all profession-als, options traders need to learn their craft and use discipline.

24. The price of an option is referred to as the ______________.

Answer: A—Premium.

Discussion: This is a fitting name, as the same term is also used for in-surance. This makes sense since options are often used as insurance



to protect long-term holdings. When buying a call option, we have theright to buy the underlying security at a future date at a specific price.We do not have to use this right, just as we don’t always use our in-surance policies (i.e., file a claim), but the option is there if we dowant to use it.

25. The ______________ is referred to as the price at which the stock orcommodity underlying a call or put option can be purchased or soldover the specified period.

Answer: B—Strike price.

Discussion: The strike price has a distinct relationship to the priceof an option. If the strike price is a long ways away from the currentvalue of the security, the premium will be low. However, if there al-ready is value in the option because it is in-the-money (ITM), the pre-mium will be much higher.

26. An option is no longer valid after its ______________.

Answer: B—Expiration date.

Discussion: Once an option hits its expiration date, which is close ofbusiness prior to the Saturday following the third Friday of eachmonth, it can no longer be exercised. If an option is out-of-the-money(OTM) at expiration, it will no longer have any value. However, if it isITM, the option holder will need to either sell it for its current valueor exercise the option to fulfill the contract. Most options contractsare bought and sold before expiration.


Answer: False.

Discussion: Options are not always available on every stock. Op-tions are often added to new stocks, but only about 40 percent of cur-rent stocks traded on the major exchanges or optionable. If a stockhas little liquidity, there is very little reason to start trading options onthe stock. The CBOE web site has a list of new optionable stocks thatcan be viewed or e-mailed to you each day.

28. Each stock option (call or put) represents ______________ shares ofa stock.

Answer: B—100.

Discussion: Generally a stock option represents 100 shares of stock.Thus, if a call option is quoted at $2, the total cost for one contract

The Big Picture 25


would be $200. If the stock is trading for $20, this means we are con-trolling $2,000 worth of stock for $200, which is leverage of 10-to-1.This allows options traders to make large profits without an over-whelming amount of risk.

29. True or False: Each futures contract has a set of unique specifications.

Answer: True.

Discussion: You are responsible for understanding the specificationsfor each futures market. Each commodity has different specificationswhen it comes to futures. This makes sense, as different commoditiesare measured in different ways. With stock, we have a share; withgold, we measure it by the ounce. Thus, each futures contract canhave a different ratio that needs to be calculated to come up with thepremium and underlying value.

30. You must be cautious trading indexes, for a few of them do not havemuch ______________.

Answer: B—Liquidity.

Discussion: We need to be cautious not only with indexes that donot have much liquidity, but with any underlying security that is illiq-uid. A lack of liquidity creates higher bid-ask spreads and also leadsto a great deal of volatility. When there is little interest in a security orindex, it is more difficult to get a good fill when you are ready to sell.

31. The most important factors for determining opportunity in a marketare ______________.

Answer: D—Liquidity and volatility.

Discussion: Liquidity is the measure of trading volume of an invest-ment security. As a general rule, the more trading volume associatedwith an investment, the more liquid, and the better the market.Volatility is a measure of the speed or movement in a market. A veryvolatile market moves fast and can provide a trader with a greaternumber of profit-making opportunities.

32. ______________ gives you the opportunity to move in and out of amarket with ease.

Answer: D—Liquidity.

Discussion: If an option is illiquid it can result in bad fills and widebid-ask spreads. With stocks, we want to see volume of at least300,000 shares traded on a daily basis. For options, volume doesn’t



necessarily have to be large, but there should be open interest of atleast 100 contracts. It’s easy to distinguish the options and stocks thathave low liquidity, as the bid and ask prices will be farther apart.

33. ______________ measures the amount by which an underlying isexpected to fluctuate in a given period of time.

Answer: A—Volatility.

Discussion: Volatility is a percentage that measures the amount bywhich the underlying stock or option is expected to change in a givenperiod of time. A stock’s volatility has a significant effect on the priceof its options. A highly volatile stock has a better chance of making asubstantial move than a low-volatility stock. A more volatile asset offerslarger swings upward or downward in price in shorter time spans thanless volatile assets. Large movements, in turn, are attractive to optionstraders who are always looking for big directional swings to make theircontracts profitable. Therefore, the options of a high-volatility stockgenerally command higher premiums. Implied volatility tells a traderhow much a stock is expected to move and is a crucial element in thepricing of an option. Understanding implied volatility is one of the mostcrucial factors in becoming a successful options trader.

MEDIA ASSIGNMENT

With the proliferation of new indexes and ETFs, take the time to viewcharts of these instruments. Look for volatile issues and get a feel for howthese securities move. Then choose a handful of stocks in various sectorsand watch them to see how they react and perform. Even if we stickstrictly to individual stock options, learning to gauge the entire sector isan important part of choosing the appropriate direction. Looking at thevolatility of a sector can also provide us with a better understanding of thevolatility of an individual stock within that sector.


Asset: A balance sheet item expressing what an individual or a corporationowns.

Assignment: Refers to the option writer’s (seller’s) obligation to sell orbuy a stock or other financial instrument at the strike price for which

The Big Picture 27


the writer sold the contract. The buyer of an option has the right (butnot the obligation) to exercise the option—that is, buy the underlyingasset at the strike price of the contract (long call) or sell (deliver) theunderlying asset to the option writer at the strike price of the contract(long put). Assignment means the options writer receives an exercisenotice by another options writer that requires him to sell (in the case ofa call) or purchase (in the case of a put) the underlying security at thespecified strike price.

Bond: A debt obligation issued by a government (i.e., Treasury bond) orcorporation (i.e., corporate bond) that promises to pay its bondholders pe-riodic interest at a fixed rate (the coupon), and to repay the principal of theloan at maturity (a specified future date). Bonds are usually issued with apar or face value of $1,000, representing the principal or amount of moneyborrowed. The interest payment is stated on the face of the bond at issue.

Capital gain: The profit realized when a capital asset is sold for a higherprice than the purchase price. Your costs (when you buy) include thecommission you paid your broker and are deducted from the proceedswhen you sell. In a mutual fund, capital gains are created when the fundbuys and sells securities. These gains are then distributed to shareholdersat least annually. Shareholders can also earn capital gains by redeemingtheir units at higher prices than they originally paid.

Commodity: Any bulk good traded on an exchange or in the cash market;examples include metals, grains, and meats.

Dividend: When companies pay part of their profits to shareholders,those payments are called dividends. A mutual fund’s dividend is moneypaid to shareholders that comes from the investment income the fundhas earned. This amount is announced before it is paid and is distrib-uted to shareholders of record on a per share basis. Dividends may bein the form of cash, stock, or property. The board of directors must declareall dividends.

Exchange-traded fund (ETF): A fund that tracks an index, but can betraded like a stock. Many ETFs have options available allowing traders toprofit from moves within a sector.

Exercise: To implement the right of the holder of an option to buy (in thecase of a call) or sell (in the case of a put) the underlying security. Whenyou exercise an option, you carry out the terms of an option contract.

Futures: A term used to designate all contracts covering the purchaseand sale of financial instruments or physical commodities for future deliv-ery on a commodity futures exchange.

Hedger: A trader who enters the market with the intent to protect a posi-tion in the underlying asset; an investor who uses the futures market to



minimize the risk in his or her business. Hedgers may be manufacturers,portfolio managers, bankers, farmers, and so on. Hedgers also use optionsto protect stock positions. For example, an investor can use a put tohedge a stock or an index put to hedge a stock portfolio.

Historic volatility: Calculated by using the standard deviation of under-lying asset price changes from close-to-close of trading going back 21 to23 days. A measurement of how much a contract price has fluctuated overa specific period of time in the past; usually calculated by taking a stan-dard deviation of price changes over a time period.

Implied volatility: The volatility computed using the actual market pricesof an option contract and one of a number of pricing models. For example,if the market price of an option rises without a change in the price of theunderlying stock or future, implied volatility will have risen.

Liability: A legal obligation to pay a debt owed. Current liabilities aredebts payable within 12 months. Long-term liabilities are debts payableover a period of more than 12 months.

Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneysthat may be required on short notice, whether for emergencies or forplanned purchases.

Option premium: The price of an option; the amount of money that theoption holder pays for the rights and the option writer receives for theobligations granted by the option.

Payable date: The date on which a declared stock dividend or a bondinterest payment is scheduled to be paid.

Speculator: An investor or trader who is willing to take large risks for achance to make large gains. For example, buying a very volatile stock andhoping to sell it a day or a week later at a higher price is speculative trading.Speculators sometimes buy puts and calls in anticipation of a short-termmove higher or lower in the underlying asset. In the futures market, a specu-lator is a trader who hopes to profit from a directional move in the underly-ing instrument and attempts to anticipate price changes and, through buyingand selling futures contracts, aims to make profits. A speculator doesn’t usethe futures market in connection with the production, processing, market-ing, or handling of a product. The speculator has no interest in making ortaking delivery.

Stock: A share of a company’s stock translates into ownership of part ofthe company. Thus, when you own any shares of a company’s stock, youown part of the company. How much you own depends on how many

The Big Picture 29


shares of stock you have. Holders of common stock are the last to be paidany profits from the company but are likely to profit most from anygrowth it has. Owners of preferred stock are paid a fixed dividend beforeowners of common stock, but the amount of the dividend doesn’t usuallygrow if the company grows.

Strike price: A price at which the stock or commodity underlying a callor put option can be purchased (in the case of a call) or sold (for a put)over the specified period. For instance, a call contract may allow thebuyer to purchase 1,000 shares of ABC at any time in the next threemonths at an exercise (strike) price of $75.



CHAPTER 3

OptionBasics

SUMMARY

In order to become a successful options trader, one must also develop anunderstanding of basic concepts such as option quotes, symbols, exer-cise and assignment, types of brokerage accounts, and the key factorsthat determine options prices. This chapter is designed to help build afoundation for successful options trading by providing a primer on theseoption basics.

Simply put, options give you the ability to control an underlying stock(or other financial instrument) that the option is written on. Each stockoption controls 100 shares of the underlying stock. If you are buying an op-tion, you will have the right, but not the obligation, to buy (in the case of acall) or sell (in the case of a put) a stock at a specific price by a certaindate. Option sellers, in contrast, have the obligation to deliver (call) or pur-chase (put) the underlying stock at a specific price by a certain date. Inother words, option buyers have rights, while option sellers have obliga-tions and the additional risk should the option holder exercise the option.If you find a stock that you are interested in trading options on, simply askyour broker whether it has options, or access the Optionetics web site tosearch for option chains.

Chapter 3 of the main text also provides an in-depth discussion of thedifference between put and call options. Particular attention is paid tostrike prices, premiums, expiration dates, and recognizing whether an op-tion is in-the-money, at-the-money, or out-of-the-money. These topics areextremely important to the active options trader. Initially such concepts

31


might seem a bit cumbersome, but through time, these basic concepts willbecome second nature to the experienced options trader.


1. A ______________ gives the buyer the right, but not the obligation, tobuy a specified number of shares or contracts of the underlying secu-rity at a predetermined price during a set period of time.

A. Futures contract.

B. Call option.

C. Stock.

D. Derivative.

2. If you sign a 12-month lease agreement with an option to buy a houseat $200,000 and the seller charges $1,000 extra just for that 12-monthoption to buy the house, that charge is called the ______________.

A. Strike price.

B. Expiration.

C. Credit.

D. Premium.


4. True or False: Once you own an option, you are obligated to buy orsell the underlying instrument.

5. Once an option ______________, you lose your right to buy or sell theunderlying instrument at the specified price.

A. Moves in-the-money.

B. Moves out-of-the-money.

C. Expires.

D. None of the above.

6. Options when bought are done so at a ______________ to the buyer.

A. Debit.

B. Credit.

C. Margin.




7. Options when sold are done so by giving a ______________ to theseller.

A. Debit.

B. Credit.

C. Margin.


8. Options are available at numerous ______________ based on theprice of the underlying instrument.

A. Premiums.

B. Margins.

C. Expiration dates.

D. Strike prices.

9. The more time until expiration, the more ______________ the premium.

A. Expensive.

B. Inexpensive.

10. True or False: Strike prices for stocks and indexes come only inmultiples of 5.

11. Name the three possible relationships strike prices have to the currentprice of the underlying asset.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

12. What is the main difference between American-style options andEuropean-style options?

____________________________________________________________

____________________________________________________________

13. What are the three possible resolutions of an options contract?

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

Option Basics 33


14. If the writer of an option receives ______________, the option has beenassigned and the writer is obligated to buy (or sell) the specified amountof underlying assets at the strike price from (or to) the assigned holder.

A. A margin call.

B. An assignment notice.

C. An exercise notice.


15. A stock option represents the right to buy or sell ______________shares of the underlying stock.

A. 50.

B. 100.

C. 250.

D. 500.

16. The stock option expiration date is always the Saturday following the______________ Friday of the expiration month.

A. First.

B. Second.

C. Third.

D. Last.

17. Strike prices for stock options come in increments of ______________for stocks over $25 per share.

A. $1.

B. $2.

C. $5.

D. $10.

18. True or False: The strike prices and expiration dates of options con-tracts differ depending on the underlying instrument they represent.

19. Name the five components that make up option symbols:

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

4. _________________________________________________________

5. _________________________________________________________



20. Name the two types of options.

1. _________________________________________________________

2. _________________________________________________________

21. A ______________ gives the buyer the right (not the obligation) to buythe underlying stock shares or futures contract.

A. Call option.

B. Put option.

C. Futures option contract.

D. Stock option contract.

22. If the market price is more than your strike price, your call option is______________.

A. At-the-money.

B. In-the-money.

C. Out-of-the-money.

23. If the market price is less than your strike price, your call option is______________.

A. At-the-money.

B. In-the-money.


24. If the market price is the same as your strike price, your option is______________.

A. At-the-money.

B. In-the-money.


25. If you buy call options, you are ______________.

A. Going long.

B. Going short.

C. Going delta neutral.

D. Hedging.

Option Basics 35


26. If you sell call options, you are ______________.

A. Going long.

B. Going short.


D. Hedging.

27. If you are ______________ (believe the market will rise), then youwant to buy calls.

A. Bearish.

B. Bullish.

28. If you are ______________ (believe the market will drop), then youwant to buy puts.

A. Bearish.

B. Bullish.

29. If you buy a call option, your risk is ______________.

A. Unlimited.

B. The price of the underlying.

C. The margin of the underlying.

D. The price of the premium.

30. If you sell a call option, your risk is ______________.

A. Unlimited.






31. If the current price of XYZ is $50, fill in the blanks designating eachstrike as ITM, ATM, or OTM.

32. Name the two ways profits can be realized from purchasing a calloption.

1. _________________________________________________________

2. _________________________________________________________

33. All the options that have the same unit of trading, expiration date,and strike price are called an ______________.

A. Option class.

B. Option series.

C. Option division.

D. Option suit.

34. A ______________ gives the buyer the right (not the obligation) to sellthe underlying stock shares or futures contract.

A. Call option.

B. Put option.

C. Futures option contract.

D. Stock option contract.

Option Basics 37

Strike Price of Option Call Option Moneyness

70

65

60

55

50

45

40

35

30


35. If the market price is less than your strike price, your put option is______________.

A. At-the-money.

B. In-the-money.


36. If the market price is more than your strike price, your put option is______________.

A. At-the-money.

B. In-the-money.


37. If the market price is the same as your strike price, your put option is______________.

A. At-the-money.

B. In-the-money.


38. If you buy put options, you are ______________.

A. Going long.

B. Going short.


D. Hedging.

39. If you sell put options, you are ______________.

A. Going long.

B. Going short.


D. Hedging.

40. If you buy a put option, your risk is ______________.

A. Unlimited.






41. If you sell a put option, your risk is ______________.

A. Limited to the stock falling to zero.





MEDIA ASSIGNMENT

In order to better understand the basics of puts and calls, let’s go to theOptionetics.com web site and create an option chain. First, connect tothe Internet and type www.optionetics.com into the title bar of your Webbrowser. Next, type a symbol for the stock or index of your choice in thequote box that appears at the top of the home page. For instance, usethe symbol QQQ. Finally, select “Chain” from the drop-down menu andclick “Go.”

After clicking “Go,” an option chain for the Nasdaq 100 QQQ will ap-pear inside your web browser. First, notice that the chain is clearly sepa-rated down the middle and consists of two groups of columns. In order tosee the latest price quotes for call options on the QQQ, the strategistneeds to look at the left side of the chain. To find information on QQQputs, one would look to the right.

Next, notice that the first rows of options list the options with theshortest amount of time remaining until expiration. For instance, if you

Option Basics 39

Strike Price of Option Put Option Moneyness

70

65

60

55

50

45

40

35

30


create this chain on January 1, 2005, the January 2005 options will appearat the top of the table. In addition, these options will be sorted based onstrike price. As you move down the table, you will notice that the expira-tion dates change. The options with the most time remaining until expira-tion appear in the last rows of the table. The option chain also providesthe option symbol, the bid price, the asking price, and the open interestfor each option.

VOCABULARY LIST

SOLUTIONS

1. A ______________ gives the buyer the right, but not the obligation, tobuy a specified number of shares or contracts of the underlying secu-rity at a predetermined price during a set period of time.

Answer: B—Call option.

Discussion: A call is a type of options contract that can be pur-chased or sold. The owner of a call option purchases the right, butnot the obligation, to buy a specified amount of the underlying secu-rity (e.g., 100 shares of XYZ stock) at a predetermined price for aspecified period of time.


American-style

Assignment

At-the-money

Automatic exercise

Credit

Debit

European-style

Exercise

Expiration date

In-the-money

Intrinsic value

Long

Moneyness

Near-the-money

Out-of-the-money

Root symbol

Series

Short

Strike price

Symbol


2. If you sign a 12-month lease agreement with an option to buy a houseat $200,000 and the seller charges $1,000 extra just for that 12-monthoption to buy the house, that charge is called the ______________.

Answer: D—Premium.

Discussion: The premium is the amount paid by the option buyerand the amount received by the option seller when entering into thecontract. There are seven major components that affect the premiumof an option:

1. The current price of the underlying financial instrument.

2. The type of option (put or call).

3. The strike price of the option in comparison to the current marketprice (intrinsic value).

4. The amount of time remaining until expiration (time value).

5. The current risk-free interest rate.

6. The volatility of the underlying financial instrument.

7. The dividend rate, if any, of the underlying financial instrument.


Answer: False.

Discussion: Options are not available on every stock. Check withyour broker or look for an option chain using www.optionetics.comto see if a stock you are interested in trading has available options.

4. True or False: Once you own an option, you are obligated to buy orsell the underlying instrument.

Answer: False.

Discussion: An option holder is not obligated to buy or sell the un-derlying instrument. The purchase of an option gives you the right—but not the obligation—to buy or sell the underlying. If you choosenot to exercise it, you can simply let the option expire worthless.

5. Once an option ______________, you lose your right to buy or sell theunderlying instrument at the specified price.

Answer: C—Expires.

Discussion: After expiration, the option ceases to exist. Therefore,the owner then has no rights and the seller has no obligation associ-ated with the contract.

Option Basics 41


6. Options when bought are done so at a ______________ to the buyer.

Answer: A—Debit.

Discussion: If a trader buys an option, the cost of the option—thepremium—is debited from the trader’s account.

7. Options when sold are done so by giving a ______________ to theseller.

Answer: B—Credit.

Discussion: If a trader sells an option, the cost of the option—thepremium—is credited to the trader’s brokerage account. For exam-ple, the call’s premium is the maximum profit available on a short op-tion position and shows up as a credit in the trader’s account.

8. Options are available at numerous ______________ based on theprice of the underlying instrument.

Answer: D—Strike prices.

Discussion: Options are assigned various strike prices that are basedon the current market price of the underlying asset. The strike priceis the fixed price at which the asset underlying an option can bepurchased (call) or sold (put).

9. The more time until expiration, the more ______________ the premium.

Answer: A—Expensive.

Discussion: An options contract with many months or years remain-ing until expiration will be worth more than an options contract withonly a few days or weeks remaining. Stated differently, the more timeremaining in the option’s life, the greater the option’s value and there-fore the greater the option premium.

10. True or False: Strike prices for stocks and indexes come only inmultiples of 5.

Answer: False.

Discussion: Strike prices may vary for stocks and indexes. In gen-eral, however, options are available at various strike prices at 2 1/2-point intervals for stocks priced $25 and less, or 5-point intervals forstocks over $25.



11. Name the three possible relationships strike prices have to the cur-rent price of the underlying asset.

Answer: In-the-money (ITM), at-the-money (ATM), out-of-the-money(OTM).

Discussion: Moneyness refers to the option’s strike price relative tothe price of the underlying asset. If the strike price is equal to theprice of the underlying asset, the option is said to be at-the-money. Ifthe strike price is higher or lower than the underlying asset price, theoption is either out-of-the-money or in-the-money depending onwhether the option is a put or a call.

12. What is the main difference between American-style options andEuropean-style options?

Answer: The only difference between American and European optionsis when they can be exercised.

Discussion: American-style options can be exercised at any time onor before their expiration dates. European options can be exercisedonly on (not before) their expiration dates. While stock options andexchange-traded funds settle American-style, most index optionshave the European-style settlement feature.

13. What are the three possible resolutions of an options contract?

Answer: The options contract may expire and become worthless, beexercised by its owner, or be assigned.

Discussion: If an out-of-the-money option is not exercised beforeexpiration, it will become worthless. If the option is in-the-moneyat expiration, it will be exercised and the option seller will be facedwith assignment of that option. For example, if the price of the un-derlying stock rises above a short call strike price before expira-tion, the short option will either be exercised or be assigned to anoption buyer. The call option seller is then obligated to deliver 100shares of the underlying stock to the option buyer at the short callstrike price. This entails buying the underlying stock at the higher(market) price and delivering it to the option buyer at the lower(strike) price. The difference between these two prices constitutesthe seller’s loss and the buyer’s open position profit. This can be ahuge loss in fast markets, which is why we never recommend sell-ing naked options.

Option Basics 43


14. If the writer of an option receives ______________, the option has beenassigned and the writer is obligated to buy (or sell) the specified amountof underlying assets at the strike price from (or to) the assigned holder.

Answer: C—An exercise notice.

Discussion: Assignment will occur if the option is in-the-money nearexpiration. If so, the Options Clearing Corporation sends an exercisenotice to a brokerage firm and the brokerage firm then delivers thenotice to the option writer.

15. A stock option represents the right to buy or sell ______________shares of the underlying stock.

Answer: B—100.

Discussion: Stock options are standardized to represent 100 sharesof the underlying stock. Futures, in contrast, vary depending on thecommodity’s characteristics.

16. The stock option expiration date is always the Saturday following the______________ Friday of the expiration month.

Answer: C—Third.

Discussion: Stock options expire at close of business prior to theSaturday after the third Friday of the expiration month. The last dayto trade them is therefore on the third Friday of the option’s expira-tion month.

17. Strike prices for stock options come in increments of ______________for stocks over $25 per share.

Answer: C—$5.

Discussion: In most cases, stocks with market prices of $25 or morewill have strike prices spaced at 5-point increments.

18. True or False: The strike prices and expiration dates of optionscontracts differ depending on the underlying instrument they represent.

Answer: True.

Discussion: Different underlying assets (stocks, indexes, futures,etc.) have different specifications for their respective options con-tracts. To find the current information regarding a contract, check theweb site of the exchange where the contract is listed for trading, orgo to www.optionetics.com and enter the stock symbol, then click onOption Chain.



19. Name the five components that make up option symbols.

Answer: Underlying financial instrument, root symbol, expirationmonth, strike price, option type.

Discussion: Each options contract can be described using threefactors. The first is the root symbol. Sometimes the root symboland the underlying financial instrument are the same; for instance,IBM is the root symbol for International Business Machines (IBM).Microsoft is an example of a stock with a root symbol that is notthe same as the stock. The stock symbol is MSFT, while the optionsymbol is MSQ. The second part of an option symbol tells the expi-ration and reflects whether the option is a put or a call (A through Lfor calls and M through X for puts). If the expiration month is Janu-ary and the option is a call, the second part of the symbol is an A; ifthe contract is a February put, the second part of the symbol is anN. Finally, the last part of the option symbol is the strike price. Theletter A is used for a strike price of 5, B for 10, C for 15, all the wayup to T for 100. Therefore, the symbol for the IBM February 75 callis IBMBO.

20. Name the two types of options.

Answer: Calls and puts.

Discussion: Calls are options that give the buyer the right to buyan underlying asset. Puts give the buyer the right to sell the under-lying asset.

21. A ______________ gives the buyer the right (not the obligation) to buythe underlying stock shares or futures contract.

Answer: A—Call option.

Discussion: If you exercise this type of option, you are calling theunderlying security away from the option seller. Hence, the optionseller is obligated to deliver 100 shares of the underlying stock to theoption holder.

22. If the market price is more than your strike price, your call option is______________.

Answer: B—In-the-money.

Discussion: If the strike price is below the market price, the optionscontract has intrinsic value because it enables the owner to purchasethe underlying asset at the lower strike price. So, it is in-the-money.

Option Basics 45


23. If the market price is less than your strike price, your call option is______________.

Answer: C—Out-of-the-money.

Discussion: A call option that has a strike price above the marketprice has no intrinsic value and is therefore out-of-the-money.

24. If the market price is the same as your strike price, your option is______________.

Answer: A—At-the-money

Discussion: When the strike price is equal to the price of the under-lying asset, whether puts or calls, the contract is at-the-money.

25. If you buy call options, you are ______________.

Answer: A—Going long.

Discussion: Anytime you buy an options contract, you are going long—even if it is a put option going long a call option is a bullish strategy.

26. If you sell call options, you are ______________.

Answer: B—Going short.

Discussion: Option sellers are said to be short the options contract.Going short a call option is a bearish strategy and comes with unlimitedrisk, which is why we never recommend selling naked options.

27. If you are ______________ (believe the market will rise), then youwant to buy calls.

Answer: B—Bullish.

Discussion: Buying a call is a bullish strategy because it allows atrader to profit from a rise in the price of the underlying asset. A longcall can also be used to predetermine how much a trader wants to payfor the underlying asset—regardless of how high the price climbs overtime until the option expires. A bull expects the market to move higher.A rising market is called bullish because bulls buck up with their horns.

28. If you are ______________ (believe the market will drop), then youwant to buy puts.

Answer: A—Bearish.

Discussion: Buying a put is a bearish strategy because it allows a traderto profit from a decline in the price of the underlying asset. A long putcan also be used to predetermine how much a trader wants to receivefor selling the underlying asset—regardless of how low the price fallsover time until the option expires. Bears expect the underlying asset to



fall. A falling market is called bearish because bears swat downwardwith their paws.

29. If you buy a call option, your risk is ______________.

Answer: D—The price of the premium.

Discussion: The total risk associated with buying an option is thecost of entering the agreement (the premium).

30. If you sell a call option, your risk is ______________.

Answer: A—Unlimited.

Discussion: Call option sellers enter into an obligation to sell the un-derlying asset at a predetermined price. If they do not already ownthe underlying asset and it moves higher in price, they will likely befaced with assignment and will be forced to buy the underlying assetto cover assignment. Furthermore, since there is theoretically nolimit to how high an underlying asset might go, the risk associatedwith selling call options is theoretically unlimited.


Answer:

Discussion: If the strike price is equal to the price of the underlyingasset, the option is said to be at-the-money. If the strike price ishigher than the underlying asset price, the call option is out-of-the-money. If the strike price is lower than the underlying asset price, thecall option is in-the-money.

Option Basics 47

Strike Price of Option Call Option Moneyness

70 OTM

65 OTM

60 OTM

55 OTM

50 ATM

45 ITM

40 ITM

35 ITM

30 ITM


32. Name the two ways profits can be realized from purchasing a calloption.

Answer:

1. If the underlying asset increases in price before the option ex-pires, the holder can purchase the underlying asset at the lowerstrike price.

2. If the underlying asset’s price increases before expiration, thevalue of the option increases and can be sold at a profit.

Discussion: Option owners can either exercise the options con-tract or close the position by selling the same number of an identi-cal options contract. For instance, if a trader holds 10 IBM January90 calls and IBM rises to $100, the trader can exercise the option,which would allow him or her to buy 1,000 shares of the stock forthe strike price of $90 and then sell those 1,000 shares in the mar-ket for $100. Alternatively, the trader could sell 10 IBM January 90calls and close the position at a profit without exercising the op-tions. In both cases, since the stock has risen from $90 to $100 ashare, a profit will be realized.

33. All the options that have the same unit of trading, expiration date,and strike price are called an ______________.

Answer: B—Option series.

Discussion: An option series describes the options on the same un-derlying asset that have the same unit of trading, strike price, andexpiration date.

34. A ______________ gives the buyer the right (not the obligation) to sellthe underlying stock shares or futures contract.

Answer: B—Put option.

Discussion: When exercising an options contract, the owner of a putwill instruct the brokerage firm to sell (or put) the underlying asset tothe option writer.

35. If the market price is less than your strike price, your put option is______________.

Answer: B—In-the-money.

Discussion: A put option has intrinsic value when the price of theunderlying asset falls below the strike price of the options contract.In that case, the option is in-the-money because it allows the holderto purchase the underlying asset at the lower strike price if exercised.



36. If the market price is more than your strike price, your put option is______________.


Discussion: A put option that has a strike price below the price ofthe underlying asset has no intrinsic value. It is out-of-the-money.

37. If the market price is the same as your strike price, your put option is______________.

Answer: A—At-the-money.

Discussion: When the strike price is equal to the underlying asset,whether puts or calls, the contract is at-the-money.

38. If you buy put options, you are ______________.

Answer: A—Going long.

Discussion: If you buy an option, you are going long that contract.Whether it is a put or a call doesn’t matter. Going long a put option isa bearish strategy.

39. If you sell put options, you are ______________.

Answer: B—Going short.

Discussion: Anytime you sell an option, you are going short. Goingshort a put option is a bullish strategy.

40. If you buy a put option, your risk is ______________.

Answer: D—The price of the premium.

Discussion: The total risk associated with buying an option is thepremium paid for that option. This is true whether the option is a putor a call.

41. If you sell a put option, your risk is ______________.

Answer: A—Limited to the stock falling to zero.

Discussion: The risk of selling puts can be substantial if the stockfalls sharply and the put writer is assigned the stock. However, unlikenaked call selling, the risk is not unlimited. It is limited due to the factthat the stock price cannot fall below zero.

Option Basics 49



Answer:

Discussion: If the strike price is equal to the price of the underlyingasset, the option is said to be at-the-money. If the strike price ishigher than the underlying asset price, the put option is in-the-money.If the strike price is lower than the underlying asset price, the put isout-of-the-money.

MEDIA ASSIGNMENT

Now that we have created an option chain, let’s make a few observa-tions. First, notice that the premiums of the calls with the same expira-tion date but different strike prices decrease as you move down thetable. Why is that? In contrast, the prices of the puts increase as youmove down the table.

Can you identify the at-the-money options? Also, notice that the pre-miums of the options with the same strike price but different expirationdates are different. The option with the shortest amount of time left untilexpiration has the smallest premium. Furthermore, in every case, the bidis less than the ask (offer) price. Do you remember what the differencebetween the bid and ask price is? As you probably recall, this is known asthe bid-ask spread.

Once you clearly understand an option chain, the various elements,


Strike Price of Option Put Option Moneyness

70 ITM

65 ITM

60 ITM

55 ITM

50 ATM

45 OTM

40 OTM

35 OTM

30 OTM


and why the prices vary among the options contracts, you probably havedeveloped a good understanding of the options basics. So, it’s time tomove on to the next chapter and the discussion of basic trading strategies.


American-style: An options contract that settles American-style canbe exercised at any time prior to expiration. Stock options settle American-style.

Assignment: The receipt of an exercise notice by an option writer thatrequires him or her to sell (in the case of a call) or purchase (in the case ofa put) the underlying security at the specified strike price.

At-the-money: Refers to an option with an exercise or strike price thatis equal, or almost equal, to the current market price of the underlyingsecurity.

Automatic exercise: An exercise by the clearing firm in which the firmautomatically exercises an in-the-money option at expiration.

Credit: Amount that is added to the trading account when an optionstrader collects a premium for selling options.

Debit: The amount that is subtracted from a trader’s account when atrade involves the net purchase of options contracts.

European-style: An option contract that can be exercised only on theexpiration date.

Exercise: To implement the right of the holder of an option to buy (in thecase of a call) or sell (in the case of a put) the underlying security. Whenyou exercise an option, you carry out the terms of an option contract.

Expiration date: The day when the options contract expires. For stockoptions, the expiration date falls on close of business prior to the Satur-day following the third Friday of the expiration month.

In-the-money: Refers to an options contract that has intrinsic value. Acall is in-the-money if the strike price is less than the market price. A putis in-the-money if the strike price is greater than the market price of theunderlying security.

Intrinsic value: The amount by which an option is in-the-money. Out-of-the-money options have no intrinsic value. To calculate the intrinsic valueof a call option, take the price of the underlying and subtract the strikeprice. A put option’s intrinsic value equals the strike price minus the priceof the underlying.

Option Basics 51


Long: Buying an investment security. Traders will go long when theyexpect the instrument to increase in value.

Moneyness: A term to define whether an options contract is in-the-money, at-the-money, or out-of-the-money.

Near-the-money: Refers to an option with a strike price that is almostequal to the current market price of the underlying security.

Out-of-the-money: Refers to an options contract that has no intrinsicvalue; for instance, a call option whose exercise price is above the currentmarket price of the underlying security or futures contract.

Root symbol: The first part of an options symbol that represents the un-derlying security. For instance, the root symbol for International BusinessMachines is IBM.

Series: All option contracts of the same class that also have the same unitof trade, expiration date, and exercise price.

Short: Selling an investment security in anticipation that the pricewill fall.

Strike price: A price at which the stock or commodity underlying acall or put option can be purchased (call) or sold (put) over the speci-fied period.

Symbol: A three-, four-, or five-letter sequence that denotes a stock, option,or futures contract.



CHAPTER 4

BasicTrading

Strategies

SUMMARY

In addition to risk graphs, Chapter 4 covers the following eight strategies:long stock, short stock, long call, short call, covered call, long put, shortput, and covered put. These are the basic strategies that almost all optionstraders first learn. In fact, many options traders begin as stock traders.From there, many move on to shorting stocks or long calls. These strate-gies, while simple and widely used, form the basis for many more complextrading strategies, which are covered in detail in later chapters.

Before initiating any options trade, the strategist needs to determinethe trade’s potential risks and rewards. A risk profile can be generated toprovide a graphical representation of the overall risk of a specific trade. Byvisualizing the potential risk and reward, a trader can find promisingtrades and identify potential pitfalls.


1. Every trade you place has a corresponding ______________ thatgraphically shows your potential risk and potential reward over arange of prices and time periods.

A. Risk curve.

B. Risk graph.

C. Risk profile.


53


2. Reading a risk profile is pretty easy. The horizontal numbers at the bottom of the chart read from left to right showing the______________.

A. Market price.

B. Option premium price.

C. Profit and loss.

D. Change in overall position delta.

3. The vertical numbers from top to bottom show ______________.

A. Market price.

B. Option premium price.

C. Profit and loss.

D. Change in overall position delta.

4. Label each risk graph with the correct strategy: long stock, long call,long put, short stock, short call, short put.



5. The long stock strategy provides ______________.

A. Limited profit potential with limited risk.

B. Limited profit potential with unlimited risk.

C. Unlimited profit potential with unlimited risk.

D. Unlimited profit potential with limited risk.

6. A stock does not have premium or time decay. It has a ______________movement in price versus risk and reward.

A. 1-to-1.

B. 1-to-2.

C. 1-to-10.

D. 1-to-100.

7. True or False: In a short stock strategy, when the stock price falls,you make money; when it rises, you lose money.

8. A short stock strategy has ______________.



C. High profit potential with unlimited risk.

D. High profit potential with limited risk.

9. True or False: With a long call strategy, when the price of the underly-ing asset rises you make money; when it falls, you lose money.

Basic Trading Strategies 55


10. A long call strategy has virtually ______________.





11. True or False: With a long call strategy, you still have to hold marginin your account to place the trade.

12. If you bought a September IBM 105 call for a premium of 5, yourminimum risk on this trade would be ______________.

A. $50 plus commissions.

B. $100 plus commissions.

C. $500 plus commissions.

D. $1,000 plus commissions.

13. The breakeven for a long call at expiration is computed by______________.

A. Adding the cost of the call option to its strike price.

B. Adding cost of the option to the price of the commission.

C. Subtracting the strike price from the option premium.

D. Subtracting the option premium from the strike price.

14. True or False: With a short call strategy, when the underlying instru-ment’s price rises, you make money; when it falls, you lose money.

15. A short call strategy has ______________.





16. True or False: With a long put strategy, when the underlying instru-ment’s price falls, you make money; when it rises, you lose money.



17. A long put strategy has virtually ______________.





18. The breakeven of a long put option by expiration is derived by______________.

A. Adding the cost of the option to its strike price.

B. Adding the cost of the option to the price of the commission.

C. Subtracting the strike price from the option premium.

D. Subtracting the option premium from its strike price.

19. True or False: In a short put strategy, when the underlying instru-ment’s price falls, you make money; when it rises, you lose money.

20. A short put strategy has ______________.


B. Limited profit potential with significant risk.

C. Unlimited profit potential with significant risk.


MEDIA ASSIGNMENT

This media assignment requires a piece of graph paper and an Internetconnection. Once your PC is booted and online, type www.cboe.cominto the Web browser, which will take you to the Chicago Board Op-tions Exchange web site. From the CBOE home page, click on the“Trading Tools” tab, then the “Volatility Optimizer,” and then click on“Options Calculator.” Next select “American” in the style box. (Note: Iffor some reason the CBOE site is not available, readers can use any op-tions calculator to complete this assignment.)

On a piece of graph paper (or a printout of an Excel spreadsheet),create a risk graph by drawing a horizontal axis and a vertical axis.Along the horizontal axis, write the numbers 60, 65, 70, 75, 80, 85, and 90 at evenly spaced intervals. From bottom to top, write the



numbers 0, 1, 2, . . . , 20 along the vertical axis. Now, go back to the options calculator.

Using the chart and the options calculator, let’s create a risk curve fora long call strategy. Remember that a long call is simply the purchase of acall option. So, let’s input some variables into the calculator regarding thislong call. First, let the strike price equal 75; the volatility is 30 percent, theannual interest rate is 5 percent, and the company pays no dividend (quar-terly dividend amount equals 0). Next, in the “Days Left to Expiration”box, click “Days Until Expiration” and enter the number 100. We are goingto look at an options contract with 100 days remaining until expiration,which has a strike price of 75, volatility of 30 percent, and an underlyingsecurity that pays no dividends.

Now, let’s look at what happens to the call option when we changethe stock price. Enter 60 into the “Equity Price” box and look at thevalue of the call. It is worth approximately 45 cents. On the risk graph,draw a dot at the coordinate where 60 and .45 meet (estimate .45 be-tween 0 and 1 on the lower left-hand side of the chart). Next, plug thenumber 65 into the “Equity Price” box on the options calculator and no-tice that the value of the long call increases to roughly 1.25. Put a dot onthe risk curve where 65 and 1.25 meet. Continue this process until youreach the stock price of 90. When you reach the final equity price valueof 90, the long call is worth roughly 16.50. Finally, connect the dots andyou have just created a risk curve for the long call. It is upwardprofit/loss line that slopes to the right.

In practice, the strategist would subtract the cost of the long call fromthe risk curve to see the true profit-and-loss potential of a long call trade.In this case, we just looked at the possible changes in the option price thatresult from changes in the stock price. We did not assume we purchasedthe long call at a specific price. If we pay, for instance, $1 for the long call,we would subtract $1 from the value of the option price. So, when thestock price is $60 a share, the loss on the trade is 55 cents: (1 – .45). How-ever, if the stock reaches $90 a share, the gain on the trade is $15.50:(16.50 – 1).

Importantly, most options strategists do not create risk curves man-ually. Instead, traders rely on software packages to create the graphs.Nevertheless, to truly understand the reward/risk profile of an optionstrade, it is helpful to also understand how and why a risk curve has agiven shape. In sum, plotting a few simple ones like the long call willhelp the reader better understand why various risk curves look the waythey do.



VOCABULARY LIST

SOLUTIONS

1. Every trade you place has a corresponding ______________ thatgraphically shows your potential risk and potential reward over arange of prices and time periods.

Answer: D—All of the above (risk curve, risk graph, risk profile).

Discussion: Risk curve, risk graph, and risk profile are often usedinterchangeably to describe a graphical representation of the risksand rewards of an options trade. Each options strategy has a corresponding risk curve that provides a simple view of the rangeof possible outcomes. We encourage options traders to focus onstrategies that have risk curves with limited risk and high rewards,and avoid risk profiles that reflect unlimited risks and limited rewards.

2. Reading a risk profile is pretty easy. The horizontal numbers at the bottom of the chart read from left to right showing the______________.

Answer: A—Market price.

Discussion: On a risk curve, the horizontal line across the bottom ofthe graph reflects the market price of the underlying asset.


Breakeven

Chicago Board Options Exchange(CBOE)

Covered call

Covered put

Long call

Long put

Long stock

Options calculator

Risk curve

Risk graph

Risk profile

Short call

Short put

Short stock


3. The vertical numbers from top to bottom show ______________.

Answer: C—Profit and loss.

Discussion: A risk graph shows the price of the underlying assetalong the horizontal axis and the profit or loss from the options tradealong the vertical axis. If the curve is upward sloping to the right, forinstance, the options strategy will show increasing profits as theunderlying asset price moves higher.

4. Label each risk graph with the correct strategy: long stock, long call,long put, short stock, short call, short put.

Answer:


Short Stock Short Put

Short Call Long Stock


Discussion: Each strategy has a unique risk curve that visuallyprojects each trade’s profit and loss potentials. This chapter ex-plores the risk graphs associated with some of the most basicstrategies.

5. The long stock strategy provides ______________.

Answer: D—Unlimited profit potential with limited risk.

Discussion: Buying stocks can involve significant risks if the stockprices move lower, but the losses will be limited to the stock falling tozero. At the same time, since there is theoretically no limit to howhigh a stock can climb, the profit potential associated with holding astock is unlimited.

6. A stock does not have premium or time decay. It has a ______________movement in price versus risk and reward.

Answer: A—1-to-1.

Discussion: Unlike an option, a stock does not include a premiumand does not suffer from time decay. Once an investor buys shares ofstock, the investor will earn $1 a share for every $1 increase in thestock price. On the other hand, if the stock falls, the investor will lose$1 a share for every $1 loss in the share price.

7. True or False: In a short stock strategy, when the stock price falls,you make money; when it rises, you lose money.

Answer: True.

Discussion: Shorting stock is a bearish strategy that traders usewhen they expect the stock price to move lower. If the stock moveshigher, the short seller suffers losses.


Long Put Long Call


8. A short stock strategy has ______________.

Answer: C—High profit potential with unlimited risk.

Discussion: Selling stocks short can have significant profit potentialif the share price falls dramatically. The possible gains are limited tothe stock falling to zero. The risks associated with short selling canalso be significant. In fact, given that there is no ceiling to how high astock can climb, the risks of short selling are theoretically unlimited.

9. True or False: With a long call strategy, when the price of the underly-ing asset rises you make money; when it falls, you lose money.

Answer: True.

Discussion: Call options appreciate in value as the price of theunderlying asset moves higher.

10. A long call strategy has virtually ______________.


Discussion: When buying a long call, the option buyer pays a pre-mium. If the underlying asset moves higher, the long call appreciatesin value. Furthermore, since there is theoretically no limit to howhigh an underlying asset can go, there is unlimited profit potential.However, the risk is always limited to the premium paid for the underlying asset.

11. True or False: With a long call strategy, you still have to hold marginin your account to place the trade.

Answer: False.

Discussion: Zero margin borrowing is allowed, which means thatyou don’t have to hold any margin in your account to place the trade.

12. If you bought a September IBM 105 call for a premium of 5, your totalrisk on this trade would be ______________.

Answer: C—$500 plus commissions.

Discussion: The risk inherent in buying options is limited to the pre-mium paid. In this case, a premium of 5 means a maximum risk of $500.

13. The breakeven for a long call at expiration is computed by______________.

Answer: A—Adding the cost of the call option to its strike price.

Discussion: To find the breakeven price for a long call, you take thestrike price of the option and add the option premium. If the price of



the underlying asset is equal to this value at expiration, the long callwill (theoretically) break even.

14. True or False: With a short call strategy, when the underlying instrument’s price rises, you make money; when it falls, you losemoney.

Answer: False.

Discussion: In a short call strategy, when the underlying instru-ment’s price falls, you make money; when it rises, you lose money.

15. A short call strategy has ______________.

Answer: B—Limited profit potential with unlimited risk.

Discussion: When selling calls, the profit is limited to the pre-mium received. However, if the underlying asset makes a movehigher, the short call strategy will begin to experience losses. If the stock makes a large percentage move higher, the losses can be significant.

16. True or False: With a long put strategy, when the underlying instru-ment’s price falls, you make money; when it rises, you lose money.

Answer: True.

Discussion: Long puts increase in value when the underlying assetfalls. If the underlying asset moves higher, the put option will experi-ence a loss of value.

17. A long put strategy has virtually ______________.

Answer: A—Limited profit potential with limited risk.

Discussion: A long put will increase in value if the underlying secu-rity moves lower. The profit can be significant if the security makesa large percentage move lower. However, since the underlying assetcannot fall below zero, the potential profits are limited. The risksinvolved are also limited and are equal to the premium paid for thelong put.

18. The breakeven of a long put option by expiration is derived by______________.

Answer: D—Subtracting the option premium from its strike price.

Discussion: If the value of the underlying asset at expiration is equalto the strike price minus the premium, the long put breaks even.



19. True or False: In a short put strategy, when the underlying instru-ment’s price falls, you make money; when it rises, you lose money.

Answer: False.

Discussion: Selling a put is a bullish strategy that profits when theprice of the underlying asset moves higher. Oftentimes, the goal inshorting a put is to collect the premium and see the option expireworthless, which allows the put writer to keep the credit receivedfrom selling the put. The put will expire worthless if it is out-of-the-money at expiration and this will occur if the price of the underlyingasset rises above the put strike price. At other times, put sellers hopeto have the put assigned and take ownership of the underlying secu-rity. In either case, when the underlying asset price rises, the putseller makes money. On the other hand, when the price of the under-lying asset falls, money will most likely be lost.

20. A short put strategy has ______________.

Answer: B—Limited profit potential with significant risk.

Discussion: Naked put selling involves significant risk if the underly-ing asset makes a large percentage move lower. While the risks arelimited to the underlying instrument falling to zero, the short putstrategy is still a very high risk aproach. The profit is also limited andis equal to the premium received for selling the put.

MEDIA ASSIGNMENT

The media assignment encourages the reader to use the free options cal-culator at the Chicago Board Options Exchange web site to create a riskcurve. Plugging the various stock prices into the calculator produces thefollowing values. For instance, with the stock at $80 a share, the long callwould be worth $8.40.


Stock Price Call Option Price

60 0.45

65 1.25

70 2.80

75 5.15

80 8.40

85 12.30

90 16.50


The next step is to plot the coordinates on the risk curve. For exam-ple, the first dot (in the lower left-hand corner of the risk graph) appearswhere the stock price equals $60 a share and the option is worth 45 cents.As we can see, the risk curve of the long call is upward sloping to theright. In later chapters, we will see how to repeat the same analysis usingmore complex strategies.


Breakeven: The point where a position shows no profits and no losses.For example, if an investor sells a stock for the same price that was paid,she will break even.

Chicago Board Options Exchange (CBOE): Established in 1973, theCBOE was the first organized options exchange in the United States.

Covered call: A strategy that involves buying stock shares and sellingcalls. If the calls are assigned, the investor must relinquish the shares. Thecovered call can be established as one position or calls can be sold againstan existing stock position.


2019181716151413121110987654321

60 65 70 75 80 85 90

Long Call Risk Curve


Covered put: A strategy that involves selling one put against the shortsale of 100 shares of stock.

Long call: The purchase of a call option in anticipation that the underly-ing asset will rise in price.

Long put: The purchase of a put option in anticipation that the underlyingasset will decline.

Long stock: A bullish strategy that involves buying and holding shares ofstock. If you buy 100 shares of XYZ, you are long XYZ.

Options calculator: A tool used by options traders to compute theoreti-cal prices, volatility, delta, and the other so-called Greeks.

Risk curve, risk graph, and/or risk profile: A graphical representationof risk and reward on a given trade as prices change.

Short call: A bearish strategy that involves selling a call option to collectthe premium.

Short put: A bullish strategy that involves selling a put option to collectthe premium.

Short stock: Selling shares of stock in anticipation that the price willgo down.



CHAPTER 5

IntroducingVerticalSpreads

SUMMARY

In this chapter, the reader delves into the world of vertical spreads. Thefollowing four strategies are examined in depth: bull call, bull put, bearcall, and bear put. An example of each strategy is included to enable thereader to witness a hands-on illustration of each specific trading tech-nique. These strategies are used to limit risk, yet they still allow optiontraders to make nice profits.

Bull call and bear put spreads are debit strategies that use optionswith at least 90 days to expiration. Bear call and bull put spreads are creditstrategies that use options that expire in less than 45 days. Since spreadsinvolve the buying and selling of options, understanding the dynamic ofthe bid-ask spread is vital to your success. In order to pay the price you arewilling to spend when placing a vertical spread, it’s best to use a limit or-der inside the bid-ask spread.

Vertical spreads are great strategies to get started with as you learnthe options game. However, since paper trading various vertical spreadscan enable options traders to learn how to trade without losing real capi-tal, these limited risk strategies should be paper traded before real moneyis put into action. After developing a strong understanding of verticalspread mechanics, a trader can use a small amount of capital to place alimited risk trade in the marketplace. Although unlimited profits cannot bemade trading vertical spreads, risks are minimized, allowing traders tostay in the game longer.

67



1. True or False: Strategic trades are typically short-term trading opportu-nities geared especially for day traders and short-term traders who donot have the opportunity to monitor the markets very closely each day.

2. True or False: Long-term trades take a while to blossom and bearfruit, which gives the long-term trader more time to develop the artof patience.

3. Delta neutral trades are hedged when the total position delta equals______________.

A. +100.

B. –100.

C. +50.

D. –50.

E. Zero.

4. Adjustments are made by ______________ in such a way as to bringthe overall trade back to delta neutral.

A. Buying instruments.

B. Selling instruments.

C. Buying or selling instruments.

D. Exiting the trade.

5. The ______________ is a high-leverage strategy consisting of goinglong one call at a lower strike price and short one call at a higherstrike price.

A. Bear call spread.

B. Bear put spread.

C. Bull call spread.

D. Bull put spread.

6. The bull call spread has ______________.







7. Calculate the maximum reward and risk and the breakeven for thefollowing bull call spread trade.

Long 1 December Bank Index ($BKX) 90 Call @ 7.80

Short 1 December BKX 100 Call @ 5.00

Maximum reward = __________________________________________

Maximum risk = _____________________________________________

Breakeven = ________________________________________________

8. In a ______________, you buy the lower strike put and sell the higherstrike put using the same number of options.


B. Bear put spread.


D. Bull put spread.

9. A bull put spread has a ______________.





10. Calculate the maximum reward and risk and the breakeven for thefollowing bull put spread trade.

Long 1 June Bank Index ($BKX) 100 Put @ 6.75

Short 1 June BKX 110 Put @ 10.50

Maximum reward = __________________________________________

Maximum risk = _____________________________________________

Breakeven = ________________________________________________

11. In a ______________, you sell the lower strike call and buy the higherstrike call using the same number of options.


B. Bear put spread.


D. Bull put spread.

Introducing Vertical Spreads 69


12. A bear call spread has a ______________.





13. Calculate the maximum reward and risk and the breakeven for thefollowing bear call spread trade.

Long 1 December IBM 90 Call @ 7.00

Short 1 December IBM 80 Call @ 11.50

Maximum reward = __________________________________________

Maximum risk = _____________________________________________

Breakeven = ________________________________________________

14. In a ______________, you buy a higher strike price put and sell alower strike price put.

A. Covered write.

B. Bear call spread.

C. Bear put spread.

D. Bull call spread.

E. Bull put spread.

15. A bear put spread has a ______________.





16. Calculate the maximum reward and risk for the following bear putspread trade.

Long 1 October IBM 95 Put @ 3.75

Short 1 October IBM 90 Put @ 2.50

Maximum reward = __________________________________________

Maximum risk = _____________________________________________

Breakeven = ________________________________________________



MEDIA ASSIGNMENT

Vertical spreads offer predetermined risks and rewards. Understandingthe risks of a trade is vital to the success of an options trader. In this exer-cise, using the Internet take the time to create various trades with theircorresponding risk graphs of the four different types of trades mentionedin this chapter. We will discuss risk graphs in more detail later, but searchthe Internet and the Optionetics site to learn all you can about the riskgraphs for the four types of trades talked about in this chapter: bull callspread, bear put spread, bull put spread, and bear call spread.

VOCABULARY LIST

SOLUTIONS

1. True or False: Strategic trades are typically short-term trading opportu-nities geared especially for day traders and short-term traders who donot have the opportunity to monitor the markets very closely each day.

Answer: False.

Discussion: Strategic trades are short-term trading opportunitiesthat are geared for traders who do have the time to monitor themarkets closely each day.

2. True or False: Long-term trades take a while to blossom and bearfruit, which gives the long-term trader more time to develop the artof patience.

Answer: True.


Ask

At-the-money (ATM)

Bear call spread

Bear put spread

Bull call spread

Bull put spread

Bid

Bid-asked spread

Credit spread

Debit spread

In-the-money (ITM)

Intrinsic value

Leg in

Limit order

Out-of-the-money (OTM)

Slippage

Time value

Vertical spread


Discussion: There is a place for long-term trades, especially forthose who cannot spend a lot of time watching the market. Thelonger-term the trade, the more fundamental analysis comes intoplay. However, technical analysis can still be used for entry and exitpoints. Though long-term trades provide more leeway to be right, atrader should still stick with appropriate exit points.

3. Delta neutral trades are hedged when the total position delta equals______________.

Answer: E—Zero.

Discussion: As the name implies, we want to have the overall deltaas close to zero as possible for delta neutral trades. When the deltastrays from zero, a trade is then showing a directional bias. Many ex-perienced traders like to use delta neutral strategies like long syn-thetic straddles so adjustments can be made along the way to bring inadditional profits and return the trade to delta neutral.

4. Adjustments are made by ______________ in such a way as to bringthe overall trade back to delta neutral.

Answer: C—Buying or selling instruments.

Discussion: In this chapter, the main text discusses the given deltafor different types of securities and options. By understanding theapproximate delta for an option, traders can make adjustments thatshift the trade back to delta neutral. For example, if a syntheticstraddle has moved higher and you are long the stock and long twoATM puts, you would have a few choices: You could sell shares ofstock to bring in some profits or add more puts. Of course, alwaysview a risk graph before making a final decision on what adjust-ments should be made.

5. The ______________ is a high-leverage strategy consisting of goinglong one call at a lower strike price and short one call at a higherstrike price.

Answer: C—Bull call spread.

Discussion: By purchasing a lower strike call and selling a higherstrike call, a trader creates a debit strategy, which becomes the maxi-mum risk in the trade. The cost of the trade is lowered by selling thehigher strike call, although the reward is also limited. Using a bull callspread allows a trader to be wrong about the direction of the underly-ing security yet experience only a minor loss.



6. The bull call spread has ______________.


Discussion: Many new traders do not initially understand the benefitsof a bull call spread because the reward is limited. However, by exam-ining various outcomes for a bull call spread, a trader will see how thisstrategy provides downside protection. Most successful traders have aspecific profit goal in mind, so it usually isn’t a big issue to have lim-ited rewards. If a trader expects the underlying to rise sharply, then astraight call or a fairly wide bull call spread should be used.

7. Calculate the maximum reward and risk and the breakeven for thefollowing bull call spread trade.

Long 1 December Bank Index ($BKX) 90 Call @ 7.80

Short 1 December BKX 100 Call @ 5.00

Answer:

Maximum reward = [(100 – 90) – 2.80] × 100 = $720 [(Difference instrikes – net debit) × 100].

Maximum risk = (7.80 – 5.00) × 100 = $280 (Net debit).

Breakeven = (90 + 2.80) = 92.80 (Lower strike price + net debit).

Discussion: The maximum risk is always the net debit for a bull callspread. We normally want to see a maximum profit that is at leasttwice as high as the maximum risk. Thus, if we spend $150 for a bullcall spread, we want to be able to possibly make at least $300. Atrader should always create a risk graph before entering a trade tosee where the maximum reward, maximum risk, and breakevenpoints fall. Traders can create bull call spreads that have large reward-to-risk ratios; but if the breakeven needs to see a very large move,this might tell us that the trade is not worth it.

8. In a ______________, you buy the lower strike put and sell the higherstrike put using the same number of options.

Answer: D—Bull put spread.

Discussion: A bull put spread is a credit spread composed of sellingthe higher strike put and buying the lower strike put. However, be-cause a bull put spread profits as long as the underlying closes abovethe higher strike, this strategy can benefit the trader in a large num-ber of situations. In general, if we sell an ATM put, the underlying cantrade sideways or higher and we still would receive the maximumprofit (the net credit). The high probability of success does comewith higher risk in the event the underlying moves lower.



9. A bull put spread has a ______________.


Discussion: Just like a debit spread, a credit spread has limited re-ward and limited risk. However, a bull put spread’s higher probabil-ity of success also means a larger risk. Nonetheless, the risk islimited and credit spread traders can make substantial profits usingthis strategy.

10. Calculate the maximum reward and risk and the breakeven for thefollowing bull put spread trade.

Long 1 June Bank Index ($BKX) 100 Put @ 6.75

Short 1 June BKX 110 Put @ 10.50

Answer:

Maximum reward = (10.50 – 6.75) × 100 = $375 (Net credit).

Maximum risk = [(110 – 100) – 3.75] × 100 = $625 [(Difference instrikes – net credit)] × 100].

Breakeven = 110 – 3.75 = 106.25 (Higher strike price – net credit).

Discussion: A bull put spread is created by combining the sale of ahigher strike put with the purchase of a lower strike put. The goal isto see the underlying asset move higher and for both puts to expireworthless. If so, the strategist will keep the net credit, which is alsothe maximum reward. Since a credit spread has a higher successrate than a debit spread, the amount at risk normally will often behigher than the possible reward. However, over time, a creditspread trader should see substantially more wins than losses. Aswith any strategy, it is important to look at a risk graph of the tradebefore entering to make sure the reward, risk, and breakeven all fityour outlook for the stock.

11. In a ______________, you sell the lower strike call and buy the higherstrike call using the same number of options.

Answer: A—Bear call spread.

Discussion: As the name implies, a bear call spread is bearish in na-ture, but uses calls to create a credit. As long as the underlying secu-rity closes at expiration below the lower strike call, the entire netpremium becomes a profit. This means that we can enter a bear callspread when we think the stock is going to trade sideways or moveslightly lower by expiration.



12. A bear call spread has a ______________.


Discussion: I believe in limiting risk in every situation, and for this rea-son I never suggest selling naked options. Instead of selling a nakedcall, you may want to consider limiting your risk by entering a creditspread. Yes, the reward is also lowered, but this keeps a trader in thegame without losing large amounts of capital on a trade gone bad.

13. Calculate the maximum reward and risk and the breakeven for thefollowing bear call spread trade.


Short 1 December IBM 80 Call @ 11.50

Answer:

Maximum reward = (11.50 – 7.00) × 100 = $450 (Net credit).

Maximum risk = [(90 – 80) – 4.50] × 100 = $550 [(Difference betweenstrikes – net credit) × 100].

Breakeven = 80 + 4.50 = 84.50 (Lower strike price + net credit).

Discussion: If IBM were to close at or below $80 at expiration, thenthis trade would achieve a maximum profit of $450. The maximumprofit is equal to the credit received. The risk is calculated by subtract-ing the net credit from the distance between strikes. The breakeven isfound by adding the net credit received to the lower strike. In thiscase, we need IBM to close at $84.50 or below to see a profit.

14. In a ______________, you buy a higher strike price put and sell alower strike price put.

Answer: C—Bear put spread.

Discussion: Using bear and put together conveys the bearish bias of adebit spread. The idea is that we can lower the cost of buying astraight put by selling a lower strike put. Though this limits the maxi-mum profit, it also lessens the trade’s risk. If the underlying moveshigher, a spread is going to see a much smaller loss than a straight put.

15. A bear put spread has a ______________.


Discussion: Sale of a lower strike put lowers the initial debit, butalso reduces the reward. A straight put makes money as the underly-ing falls all the way to zero. However, a bear put spread is a limited



reward, limited risk strategy. If you expect the stock to fall sharply,you might be better served using a straight put. If you predetermineyour exit price, then using a debit spread might work best.

16. Calculate the maximum reward and risk for the following bear putspread trade.

Long 1 October IBM 95 Put @ 3.75

Short 1 October IBM 90 Put @ 2.50

Maximum reward = [(95 – 90) – 1.25] × 100 = $375 [(Difference instrikes – net debit) × 100].

Maximum risk = (3.75 – 2.50) × 100 = $125 (Net debit).

Breakeven = (95 – 1.25) = 93.75 (Higher strike price – net debit).

Discussion: The maximum risk for a bear put spread is the initialdebit to enter the trade. Since a bear put spread combines the sale ofa put with the purchase of a higher strike put, the net debit will belower than when buying a straight put. The maximum reward in thisexample takes place if IBM closes at or below 90 at expiration. Inthis case, a profit of $375 occurs. This is calculated by subtractingthe initial debit from the difference in strike prices. The breakevenpoint is calculated by subtracting the net debit from the higherstrike. Thus, the trade makes a profit if IBM closes at or below $93.75at expiration.

MEDIA ASSIGNMENT

When it comes to trading, practice really does make perfect. To learn theinner workings of the four strategies described in this chapter, take advan-tage of the My Portfolio section of the Optionetics web site to set up andtrack vertical spread trades. Just register at the site and you’re ready tostart searching for promising trades that will enable you to learn howthese strategies work using real-world markets.

In addition, the Optionetics web site has hundreds of insightful articlesabout a multitude of topics that can be reviewed. Use the article search fea-ture to find articles about the various vertical spreads. Though many articleswill have a recurring theme, we often learn best by repetition and slight vari-ances in the way a topic is taught. Traders can also use the discussion boardson the Optionetics web site to get feedback and information from othertraders as well as from various Optionetics writers and instructors.




Ask: The lowest price acceptable to a prospective seller of a security. Alow demand for a stock translates to the market being offered down to thelowest price at which a person is willing to sell. Off-floor traders buy at theask price and sell at the bid price. Together, the bid and ask prices consti-tute a quotation or quote, and the difference between the two prices is thebid-ask spread. The bid-ask dynamic is common to all stocks and options.

At-the-money (ATM): When the strike price of an option is the same asthe current price of the underlying instrument.

Bear call spread: A strategy in which a trader sells a lower strike call andbuys a higher strike call to create a trade with limited profit and limitedrisk. A fall in the price of the underlying increases the value of the spread.Net credit transaction; maximum loss = difference between the strikeprices less net credit; maximum gain = net credit.

Bear put spread: A strategy in which a trader sells a lower strike put andbuys a higher strike put to create a trade with limited profit and limitedrisk. A fall in the price of the underlying increases the value of the spread.Net debit transaction; maximum loss = net debit; maximum gain = differ-ence between strike prices less the net debit.

Bull call spread: A strategy in which a trader buys a lower strike call andsells a higher strike call to create a trade with limited profit and limitedrisk. A rise in the price of the underlying increases the value of the spread.Net debit transaction; maximum loss = net debit; maximum gain = differ-ence between strike prices less the net debit.

Bull put spread: A strategy in which a trader sells a higher strike put andbuys a lower strike put to create a trade with limited profit and limitedrisk. A rise in the price of the underlying increases the value of the spread.Net credit transaction; maximum loss = difference between strike pricesless credit; maximum gain = net credit.

Bid: The bid is the highest price a prospective buyer is prepared to pay fora trading unit of a specified security. If there is a high demand for the un-derlying asset, the prices are bid up to a higher level. Off-floor traders sellat the bid price and buy at the ask price.

Bid-asked spread: The difference between bid and offer prices. The termasked is usually used in over-the-counter trading. The term offered is usedin exchange trading. The bid and asked, or offered, prices together com-prise a quotation, or quote.

Credit spread: The difference in value of two options, where the value ofthe one sold exceeds the value of the one purchased to create a net creditfor the combined position.



Debit spread: The difference in value of two options, where the value ofthe long position exceeds the value of the short position to create a netdebit for the combined position.

In-the-money (ITM): If you were to exercise an option and it would gen-erate a profit at the time, it is known to be in-the-money. A call option is in-the-money if the strike price is less than the market price of theunderlying security. A put option is in-the-money if the strike price isgreater than the market price of the underlying security.

Intrinsic value: The amount by which a market is in-the-money. Out-of-the-money options have no intrinsic value. Call Intrinsic value = underly-ing – strike price. Put Intrinsic value = strike price – underlying.

Leg in: When a trader enters each part of a spread separately instead ofentering the trade as one order with his or her broker.

Limit order: An order to buy a stock at or below a specified price or tosell a stock at or above a specified price. For instance, you could tell abroker, “Buy me 100 shares of XYZ Corporation at $8 or less” or “Sell 100shares of XYZ at $10 or better.”

Out-of-the-money (OTM): Refers to an option whose exercise price hasno intrinsic value. A call option is out-of-the-money if its exercise or strikeprice is above the current market price of the underlying security. A putoption is out-of-the-money if its exercise or strike price is below thecurrent market price of the underlying security.

Slippage: The difference between estimated transaction costs and actualtransaction costs. The difference is usually composed of price revisions orspread and commission costs.

Time value: The amount by which the current market price of an optionexceeds its intrinsic value. The intrinsic value of a call is the amount bywhich the market price of the underlying security exceeds the strike priceat which the option may be exercised. The intrinsic value of a put is calcu-lated as the amount by which the market price of the underlying securityis below the exercise price.

Vertical spread: A spread in which one option is bought and one optionis sold, where the options are of the same type, have the same underlying,and have the same expiration date, but have different strike prices.



CHAPTER 6

DemystifyingDelta

SUMMARY

In this chapter, the reader is introduced to the basics of delta neutral trad-ing. Two of the most important market characteristics—volatility and liq-uidity—are discussed at length. In addition, the Greek options term delta

is explored in detail and the mechanics of delta neutral trading are intro-duced. In order to utilize the various strategies that can be created usingoptions, futures, and stock, traders need to understand how volatility andliquidity impact these trading tools.

Delta neutral trading is a common way for floor traders to minimizerisk. However, retail traders can also use delta neutral strategies tomake profits while minimizing risk. In order to fully understand deltaneutral trading, traders must develop a strong understanding of deltaand how it is calculated. In general, long calls and short puts have posi-tive deltas, whereas short calls and long puts have negative deltas. Onehundred shares of stock correspond to a fixed delta of plus 100 deltaswhen purchased and minus 100 deltas when sold short. A delta neutraltrade combines long and short deltas to create an overall position deltaof zero.

79



1. Locating opportunities for delta neutral trades depends on findingmarkets with ______________.

A. High liquidity and high volatility.

B. High liquidity and low volatility.

C. Low liquidity and high volatility.

D. Low liquidity and low volatility.

2. True or False: The higher an asset’s volatility, the higher the prices ofits options.

3. A market’s ______________ can be defined as the amount of volumethat enables a trader to buy or sell a security or derivative and receivefair value for it.

A. Volatility.

B. Equilibrium level.

C. Support.

D. Liquidity.

4. True or False: Delta neutral strategies are suitable for day trading.

5. A stock option’s delta can be calculated by ______________ and mul-tiplying by 100.

A. Dividing the change in the premium by the change in the price ofthe underlying.

B. Dividing the change in the price of the underlying by the changein the premium.

C. Multiplying the change in the premium by the change in the priceof the underlying.

D. Multiplying the change in the price of the underlying by thechange in the premium.

6. One hundred shares of stock have fixed deltas of ______________.

A. Plus 50.

B. Minus 50.

C. Plus or minus 50.

D. Plus or minus 100.



7. Long call options have ______________ deltas.

A. Positive.

B. Negative.

8. Short put options have ______________ deltas.

A. Positive.

B. Negative.

9. As a rule of thumb, the deeper ______________ your option is, thehigher the delta.

A. In-the-money.

B. Out-of-the-money.

10. ______________ options have a delta of plus or minus 50.

A. In-the-money.


C. At-the-money.

11. When an option is very deep ______________, it will start acting verymuch like the underlying stock.

A. In-the-money.


C. At-the-money.

MEDIA ASSIGNMENT

Understanding how delta impacts a trade is vital to learning how to tradedelta neutral. Though there are many trading-related web sites, therearen’t many sites that provide the delta for an option. If you have access tothe Optionetics Platinum site or if you use an options program from an-other source, take the time to learn about delta. If you don’t have any ofthese, you can use an options calculator to figure the delta of an option.Your assignment is to look at different options and decide what delta youthink would be associated with that option. After you have done this withseveral options, check the actual data to see how close you were. After awhile, you’ll be surprised how accurate your initial decision about thedelta is compared with the actual delta.

Demystifying Delta 81


VOCABULARY LIST

SOLUTIONS

1. Locating opportunities for delta neutral trades depends on findingmarkets with ______________.

Answer: A—High liquidity and high volatility.

Discussion: Delta neutral trades rely on magnitude of movementin the underlying security. High volatility often scares away newtraders; but an experienced trader usually thrives on volatility.When a stock or an index shows a lot of movement, this volatilityenables delta neutral traders to make profits even while minimizingrisk. However, in order to take advantage of high volatility, a tradermust understand the characteristics of volatility and delta. High liq-uidity is also needed to get your order filled at a good price whenentering and exiting a trade.

2. True or False: The higher an asset’s volatility, the higher the prices ofits options.

Answer: True.

Discussion: Volatility tells a trader how much the stock is ex-pected to move. This means the higher the volatility, the greater the chance of a move of sufficient magnitude in the underlying as-set. An option premium is like an insurance premium, which meanswe pay more when there is more associated risk. If volatility ishigh, the stock is expected to move a great deal more; thus the premium to enter a call or put is higher. A delta neutral traderthrives on high volatility, as it increases the chances of marketmoves of high magnitude, which provides for a number of profit-making opportunities.


Delta

Derivatives

Liquidity

Long-term equity anticipationsecurities (LEAPS)

Position delta

Skew

Tick

Volatility


3. A market’s ______________ can be defined as the amount of volumethat enables a trader to buy or sell a security or derivative and receivefair value for it.

Answer: D—Liquidity.

Discussion: When a stock or option has low liquidity, the price tendsto be skewed. Retail traders buy at the ask and sell at the bid, so it isimportant to find options with high liquidity so the bid-ask spread isnot too wide. Slippage is the amount of money lost by buying at theask and selling at the bid. With options that have low liquidity, thespread will often be large and it will be difficult to get fair value forthe options.

4. True or False: Delta neutral strategies are suitable for day trading.

Answer: False.

Discussion: Though delta neutral trades are used by floor traders tohedge risk, it is usually not suitable to day trade this type of strategy. Irecommend trying to reduce risk and stress by utilizing delta neutraltrading techniques over a longer trading period.

5. An option’s delta can be calculated by ______________ and multiply-ing by 100.

Answer: A—Dividing the change in the premium by the change in theprice of the underlying.

Discussion: Options are derivatives, so their price is derived fromthe movement of the underlying security. Delta measures the move inan option’s price as compared to a move in the underlying security.For example, if a stock moves $1 and the option moves higher by$0.50, then the delta is considered to be 50. An ATM option normallyhas a delta near 50, with ITM options seeing higher deltas and OTMoptions seeing lower deltas. A delta of 50 means that the underlyinghas a 50 percent chance of becoming in-the-money by expiration.

6. One hundred shares of stock have fixed deltas of ______________.

Answer: D—Plus or minus 100.

Discussion: One hundred shares of long stock have a delta of +100.One hundred shares of short stock have a delta of –100. No matterhow the stock price fluctuates, the delta of plus or minus 100 will re-main fixed. It is important to understand what the delta is for differ-ent securities so that combinations can be formed to create deltaneutral trades.



7. Long call options have ______________ deltas.

Answer: A—Positive.

Discussion: A long call would have a delta between 0 and 100. A longcall can’t have a delta higher than 100 because the most a call optioncan move is point-for-point with the underlying security. The deeperITM the call option gets, the closer to 100 the delta will become. Thefarther OTM the option gets, the closer to zero the delta gets.

8. Short put options have ______________ deltas.

Answer: A—Positive.

Discussion: With a short put, a trader profits as the stock moveshigher, and this means the delta is positive. (A long put would have anegative delta because the option makes money as the underlying de-clines.) Though in general Optionetics doesn’t advocate trading shortputs, or any naked options, there are times when using these types ofoptions is advisable to create delta neutral trades.

9. As a rule of thumb, the deeper ______________ your option is, thehigher the delta.

Answer: A—In-the-money.

Discussion: As an option moves deeper in-the-money, it starts to mir-ror the movement of the underlying. A very deep ITM option will havevery little time value and will start to trade nearly point-for-point withthe underlying security. The opposite also holds true: An option thatis far OTM will see little movement for each point move in the under-lying security.

10. ______________ options have a delta of plus or minus 50.

Answer: C—At-the-money.

Discussion: In most cases, ATM options have a delta that is veryclose to 50. Another way of looking at this is to say that an ATM op-tion has a 50/50 proposition of finishing in-the-money. A straddle is acommon delta neutral strategy that uses an ATM put and an ATM call,which produces an overall delta near zero.

11. When an option is very deep ______________, it will start acting verymuch like the underlying stock.


Discussion: An options contract will start to move point for pointwith the underlying once it is very deep in-the-money. Some traders



like to use deep ITM LEAPS as a proxy for buying a stock. This is be-cause they get nearly a point move in the option for each point movein the underlying security, but the initial capital outlay is smaller.

MEDIA ASSIGNMENT

This media assignment asks the reader to calculate the deltas associatedwith various options. Though we can find this data on various softwareprograms, it is good to have a basic understanding initially when lookingat various option trades. Take some time to set up a few trades using thestrategies already covered in this book and calculate each trade’s overallposition delta. Keep in mind how the delta impacts the trade. By thor-oughly understanding this concept, you will be able to create winning op-tions trades and have an easier time making additional profits by adjustinga trade back to delta neutral.


Delta: The amount by which the price of an option changes for everydollar move in the underlying instrument.

Derivatives: Derivatives are financial instruments whose value is basedon the market value of an underlying asset such as a stock, bond, or com-modity. Examples of derivatives are futures contracts, options, and for-ward contracts. Derivatives are generally used by institutional investorsto increase overall portfolio return or to hedge portfolio risk.

Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneythat may be required on short notice, whether for emergencies or forplanned purchases.

Long-term equity anticipation securities (LEAPS): LEAPS arelong-term stock or index options with expiration dates up to threeyears in the future. Like all options, they are available in two types:calls and puts.

Position delta: The sum of all positive and negative deltas in a hedgedposition.

Skew: A descriptive measure of lopsidedness in a distribution. It is es-pecially important for options trading when there is volatility skew and



prices are greater or less than they should be at various strikes and/orexpirations.

Tick: The smallest possible movement (up or down) in the price of a security.

Volatility: The magnitude of price (or yield) changes over a predefinedperiod of time. The amount by which an underlying instrument fluctuatesin a given period of time. Options often increase in price when there is arise in volatility even if the price of the underlying doesn’t move any-where. Volatility is a primary determinant in the valuation of options.There are two main types of volatility: historical and implied.



CHAPTER 7

TheOther

Greeks

SUMMARY

The option Greeks are a set of measurements that provide insight into atrade’s risk exposure. This chapter reviews the four basic option Greeks—delta, gamma, theta, and vega—while analyzing their trading applications.In addition, the chapter examines how intrinsic value, time value, andvolatility impact option premiums.

The Greeks help options traders minimize risk by telling us how thevalue of a trade will change due to fluctuations in price, time, and volatil-ity. An option has two types of value: intrinsic and extrinsic. Intrinsic valueis the real value of an option and is the amount an option is in-the-money.Intrinsic value is not affected by theta, or the passing of time. Extrinsicvalue, or time value, is impacted by theta. The deeper ITM an option is, theless extrinsic value the option has. An ATM or OTM option has no intrinsicvalue and is completely made up of extrinsic or time value. Since each op-tion comes with an expiration date and as each day passes some timevalue is lost, options are called wasting assets. This is why it is importantto understand theta and how it impacts an option’s price over time.

Volatility has two meanings in the options field—one being historicvolatility, the other implied volatility (IV). By understanding the volatilityof the underlying security, we can find discrepancies in pricing. Impliedvolatility is a major part of an option’s price, so when we see options thatare showing IV that is higher than normal, we can benefit by selling the op-tion. The same holds true for options showing low IV compared to pastvalues, as we can buy options to benefit from a rise in IV.

87



1. Option Greeks are a set of measurements that explore the______________ of a specific trade.

A. Parameters.

B. Delta neutral opportunities.

C. Risk exposures.

D. Risk-to-reward ratios.

2. Name the four basic option Greeks.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

4. _________________________________________________________

3. Fill in the option Greek term next to its appropriate definition.

4. The two most important components of an option’s premium are______________.

A. Intrinsic value and extrinsic value.

B. Vega and extrinsic value.

C. Intrinsic value and vega.

D. Gamma and theta.

5. For a call option, intrinsic value is equal to ______________.

A. The strike price of the call option minus the current price of theunderlying.


Greek Definition

Change in the delta of an option with respect to the change in __________ price of its underlying security.

Change in the price of an option relative to the price change of __________ the underlying security.

Change in the price of an option with respect to a change in its __________ time to expiration.

Change in the price of an option with respect to its change in __________ volatility.


B. The strike price of the call option plus the current price of theunderlying.

C. The current price of the underlying minus the strike price of thecall option.

D. The current price of the underlying plus the strike price of thecall option.

6. For a put option, intrinsic value is equal to ______________.

A. The strike price of the put option minus the current price of theunderlying.

B. The strike price of the put option plus the current price of theunderlying.

C. The current price of the underlying minus the strike price of theput option.

D. The current price of the underlying plus the strike price of the putoption.

7. If a call or put option is out-of-the-money, the intrinsic value is equalto ______________.

A. The strike price of the option.


C. The price of the underlying minus the strike price of the option.

D. Zero.

8. True or False: The intrinsic value of an option does not depend onhow much time is left until expiration.

9. Time value ______________ as an option approaches expiration.

A. Increases.

B. Decreases.

C. Stays the same.

10. Time value is also known as ______________.

A. Delta.

B. Gamma.

C. Theta.

D. Vega.

The Other Greeks 89


11. The more ______________ an option is, the less it costs.

A. At-the-money.

B. In-the-money.


12. If a call option’s price is less than its exercise value, investors wouldbuy the calls and exercise them, making a guaranteed ______________before commissions.

A. Margin.

B. Credit.

C. Debit.

D. Arbitrage profit.

13. On expiration day, all an option is worth is its ______________.

A. Time value.

B. Extrinsic value.

C. Intrinsic value.

D. Fair market value.

14. The deeper ______________ a call or put option is, the more the optionmoves like the underlying asset.

A. In-the-money.


15. Name the seven components that contribute to option pricing.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

4. _________________________________________________________

5. _________________________________________________________

6. _________________________________________________________

7. _________________________________________________________



16. ______________ is defined as the amount by which an underlyingfluctuates in a given period of time.

A. Risk-free interest rate.

B. Liquidity.

C. Dividend payment.

D. Volatility.

17. Name and describe the two main kinds of volatility.

1. _________________________________________________________

_________________________________________________________

2. _________________________________________________________

_________________________________________________________

18. Name three things understanding volatility can help you to accomplish.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

19. ______________ is the Greek term that represents volatility.

A. Delta.

B. Gamma.

C. Theta.

D. Vega.

20. Buying options before implied volatility ______________ can causesome trades to actually end up losing money even when the price ofthe underlying asset moves in your direction.

A. Rises.

B. Drops.

C. Stays the same for more than one week.

D. Stays the same for more than one month.

The Other Greeks 91


21. When an option’s actual price differs from the theoretical price byany significant amount, you can take advantage of the situation by______________, expecting the prices to fall back in line as the expi-ration date approaches.

A. Selling options with low volatility and buying options with highvolatility.

B. Selling or buying options with low volatility.

C. Buying options with low volatility and selling options with highvolatility.

D. Buying or selling options with high volatility.

MEDIA ASSIGNMENT

The Greeks are an integral part of understanding the risk associatedwith various options strategies. As a result, it is important to grasp howthese factors impact a trade. One of the best ways to see how theGreeks work is to experiment with an options calculator. If you haveaccess to the Optionetics Platinum site (you can always sign up for afree two-week trial at www.optionetics.com/platinum), there is an op-tions calculator that can be used. Or you can use the calculator avail-able at www.cboe.com. By entering different variables for impliedvolatility, expiration, and strike price, we get changes in the Greeks.Seeing how the Greeks relate to each other is a great way to gain a bet-ter understanding of them and the risks associated with various optionsstrategies.

VOCABULARY LIST


Black-Scholes option pricingmodel

Delta

Extrinsic value

Gamma

Historic volatility

Implied volatility

Intrinsic value

Theta

Time decay

Vega


SOLUTIONS

1. Option Greeks are a set of measurements that explore the______________ of a specific trade.

Answer: C—Risk exposures.

Discussion: Each Greek encompasses various aspects of an option’srisk. By understanding the Greeks you gain a better understanding ofthe risks of a trade. You can also make adjustments to a trade onceyou understand the delta dynamic. The key to successfully tradingoptions is to maximize profits while minimizing risks. Understandinghow to apply the Greeks is a prime factor in being able to accomplishthis task.

2. Name the four basic option Greeks.

Answer: Delta, gamma, theta, and vega.

Discussion: Since each option Greek covers a specific risk, under-standing each value is important to successful options trading. Deltais the most common and best-known Greek and rightfully so, but thisdoesn’t mean the other Greeks aren’t important. Depending on thetype of trade entered, a different Greek might be the most important.When selling short-term options, theta is very important. If you don’twant to see a sharp move in the stock, pay attention to gamma. Notonly is it important to understand each Greek individually, but it alsois valuable to understand how they relate to each other.

3. Fill in the option Greek term next to its appropriate definition.

Answer:

Discussion: These Greeks cover the basics of risk management foran option trade. Depending on the strategy implemented, different

The Other Greeks 93

Greek Definition

Gamma Change in the delta of an option with respect to the change in price of its underlying security.

Delta Change in the price of an option relative to the price change of the underlying security

Theta Change in the price of an option with respect to a change in its time to expiration.

Vega Change in the price of an option with respect to its change in volatility.


Greeks might have the most impact on the trade. We often find thatall the Greeks are important for certain trades, though one or theother might be the Greek that is the biggest risk to the trade. Once weunderstand the risks in the trade, we can make adjustments by offset-ting the risks. For example, if we want to stay delta neutral and wefind that a trade has become heavy on delta, we can buy puts or sellcalls to adjust the delta back to zero.

4. The two most important components of an option’s premium are______________.

Answer: A—Intrinsic value and extrinsic value.

Discussion: Intrinsic and extrinsic value combine to make up the totalvalue of an option. If an option is ATM or OTM it is made up completelyof extrinsic (time) value. If this is the case, the option has higher thetarisk. An ITM option is made up of both intrinsic and extrinsic value.However, as the option moves further ITM, its extrinsic value de-creases—the more it is worth and the less time value it has. The fartherOTM an option gets, the less it is worth and the more theta is a problem.

5. For a call option, intrinsic value is equal to ______________.

Answer: C—The current price of the underlying minus the strikeprice of the call option.

Discussion: A call option is ITM when the price of the underlying isabove the strike price. If a call option is ITM, the intrinsic value willnot be impacted by the passage of time. However, movement in theunderlying will have a dramatic impact on the price of the option.

6. For a put option, intrinsic value is equal to ______________.

Answer: A—The strike price of the put option minus the currentprice of the underlying.

Discussion: A put option is ITM when the underlying is trading be-low the strike price. If a put option is ITM, the intrinsic value willnot be impacted by the passage of time. However, movement in theunderlying will have a dramatic impact on the price of the option.

7. If a call or put option is out-of-the-money, the intrinsic value is equalto ______________.

Answer: D—Zero.

Discussion: Both OTM and ATM options have the largest amount oftime value for an option series. This means that theta will have amajor impact on the price of the option going forward. ATM optionsnormally have the most liquidity as well.



8. True or False: The intrinsic value of an option does not depend onhow much time is left until expiration.

Answer: True.

Discussion: Only extrinsic value is affected by the passage of time.This is why it is important to understand what extrinsic and intrinsicvalue measure so that the proper risk management can be used. For ex-ample, you rarely want to be long options with less than 30 days untilexpiration. Why? Because theta has a more dramatic impact on timevalue during the last 30 days of an option’s life.

9. Time value ______________ as an option approaches expiration.

Answer: B—Decreases.

Discussion: As the name infers, time has value. Thus, as time passes,its value decreases. However, time decay or theta accelerates in thelast 30 days of an option’s life. This is why we suggest buying optionswith at least 90 days until expiration so that time decay is not a majorfactor. We also do not normally hold long options once we have lessthan 30 days until expiration.

10. Time value is also known as ______________.

Answer: C—Theta.

Discussion: Theta is the Greek that represents time decay and timevalue. Theta tells us how much the option will lose each day due to timedecay. If we sell an option, theta is positive. The option will increase invalue due to the passage of time and the impact of time decay.

11. The more ______________ an option is, the less it costs.


Discussion: When an option is OTM, it has no intrinsic value and theodds of the option finishing ITM are lower. The further OTM the op-tion gets, the less it will cost. Buying deep OTM options is a lot likebuying a lottery ticket. If an option is several strikes OTM, it mighthave a delta of 10 to 15, which means there is only a 10 to 15 percentchance the option will finish in-the-money by expiration.

12. If a call option’s price is less than its intrinsic value, investors wouldbuy the calls and exercise them, making a guaranteed ______________before commissions.

Answer: D—Arbitrage profit.

Discussion: This occurs very infrequently, but it is important to un-derstand the concept. If the call option we hold is trading for less

The Other Greeks 95


than the intrinsic value of the option, we are better off exercising theoption and taking the guaranteed profits. If an option is trading for$4.95, but is $5.00 ITM, we could exercise the option and pocket the$0.05 difference.

13. On expiration day, all an option is worth is its ______________ .

Answer: C—Intrinsic value.

Discussion: This should make sense because when time is up, allthat is left is actual value or intrinsic value. An option that is OTM willsee a sharp decrease in value as expiration day approaches.

14. The deeper ______________ a call or put option is, the more the optionmoves like the underlying asset.


Discussion: As an option moves deeper ITM, its delta increases andthis means the option starts to move more like the underlying secu-rity. For example, a deep ITM call might have a delta of 90, whichmeans that for every dollar move in the underlying, the option willincrease by $0.90.

15. Name the seven components that contribute to option pricing.

Answer:

1. The current price of the underlying financial instrument.

2. The strike price of the option.

3. The type of option (put or call).

4. The amount of time remaining until expiration.

5. The current risk-free interest rate.

6. The volatility of the underlying financial instrument.

7. The dividend rate, if any, of the underlying financial instrument.

Discussion: All seven of these components have an impact on an op-tion’s price. Some have a larger impact than others. We didn’t discusshow interest rates and dividends affect option prices because their ef-fects are minimal as compared with the other five. Using an optionscalculator, a trader can identify the values for the different Greeks.

16. ______________ is defined as the amount by which an underlyingfluctuates in a given period of time.

Answer: D—Volatility.

Discussion: Volatility is an important component in trading options.Many traders see volatility as a negative, but used the right way,



volatility is a great tool for making profits. However, we need to under-stand what is meant by volatility and the different meanings that it has.

17. Name and describe the two main kinds of volatility.

Answer:

1. Historical volatility gauges price movement in terms of past per-formance and is calculated by using the standard deviation of theunderlying asset’s price changes from close-to-close of trading go-ing back 21 to 23 days (or any predetermined time frame).

2. Implied volatility approximates how much the marketplace thinksprices will move and is calculated by using an option pricing model(Black-Scholes for stocks and indexes and Black for futures).

Discussion: Historical volatility is the past and though this doesn’thave an impact on the future, it can be a guide to how the stock mightbe expected to trade. Implied volatility, calculated using an optionpricing model, is the volatility that is expected in the future. Much ofthe time, historic and implied volatility run close together, but thereare times when they differ and these divergences are good times toutilize various option strategies.

18. Name three things understanding volatility can help you to accomplish.

Answer:

1. Helps you to choose and implement the appropriate option strategy.

2. Holds the key to improving your market timing.

3. Helps you to avoid the purchase of overpriced options or the saleof underpriced options.

Discussion: All three of these factors are very important, as they allhelp options traders limit risk and maximize profits. By knowing whenimplied volatility is high, we can avoid buying overpriced options andconcentrate on selling them. When IV is low, going long options is of-ten a good strategy, while selling options isn’t. There are various op-tion strategies that take advantage of the different levels of IV.

19. ______________ is the Greek term that represents volatility.

Answer: D—Vega.

Discussion: Vega tells us how much an option’s price will change fora percentage change in IV. A change in IV can have a major impact onan option’s price, so it is important to understand how vega impacts atrade. IV can rise sharply even without movement in the underlyingsecurity, so it is important to know how the option will be affected bythis change in IV. This is what vega tells us.

The Other Greeks 97


20. Buying options before implied volatility ______________ can causesome trades to actually end up losing money even when the price ofthe underlying asset moves in your direction.

Answer: B—Drops.

Discussion: This is called a volatility crush and it is discouragingwhen it happens. It is frustrating to be right about direction, but seeyour option gain nothing or actually lose money. This often happenswhen a pending news announcement is released such as earnings or aFood and Drug Administration (FDA) decision. The idea is that IVrises ahead of the report, but drops sharply once the news is actuallyout. This is why we do not normally want to buy options that areshowing relatively high IV.

21. When an option’s actual price differs from the theoretical price byany significant amount, you can take advantage of the situation by______________, expecting the prices to fall back in line as the expi-ration date approaches.

Answer: C—Buying options with low volatility and selling optionswith high volatility.

Discussion: Implied volatility is like elastic, stretching to extremesbut normally coming back to an average level. This is called mean re-version and it allows options traders to take advantage of situationswhen the actual price varies from the theoretical price.

MEDIA ASSIGNMENT

The mathematics of options can be rather complicated, but the use of anoptions calculator is important to a trader’s success. We need to knowonly a few different variables and we can calculate the Greeks as well asthe implied volatility of a stock. Experimenting with an options calculatorshould provide some insight to how the Greeks change in relation to vari-ous changes in other Greeks or movement by the underlying security.


Black-Scholes option pricing model: A model used to calculate optionpricing based on a variety of factors including: the risk-free interest rate,the standard deviation of the underlying stock, time left until expiration,and the exercise (strike) price.




Extrinsic value: The price of an option less its intrinsic value. An at-the-money or out-of-the-money option’s worth consists of nothing but extrin-sic or time value.

Gamma: The degree by which the delta changes with respect to changesin the underlying instrument’s price.

Historic volatility: A measurement of how much a contract’s price hasfluctuated over a period of time in the past; usually calculated by taking astandard deviation of price changes over a specific time period.

Implied volatility: Volatility computed using the actual market price ofan option and a pricing model (Black-Scholes). For example, if the marketprice of an option rises without a change in the price of the underlyingstock or future, implied volatility will have risen.

Intrinsic value: The amount by which a market is in-the-money. At-the-money and out-of-the-money options have no intrinsic value. CallIntrinsic value = underlying – strike price. Put Intrinsic value = strikeprice – underlying.

Theta: The ratio of the change in an option’s price to the decrease in itstime to expiration.

Time decay: The amount of value lost in an option due to the passage oftime.

Vega: The amount by which the price of an option changes when thevolatility changes.

The Other Greeks 99


CHAPTER 8

Straddles,Strangles,

and Synthetics

SUMMARY

This chapter reviews several delta neutral strategies including straddles,strangles, and synthetic straddles. These strategies are based on optimalmathematical relationships and have a high probability of profitability ifapplied in suitable markets. Examples of each strategy are included to en-able the reader to become fully acquainted with the calculations of risk, re-ward, and breakevens. This chapter covers both limited risk and unlimitedrisk strategies (short straddles and short strangles). Keep in mind that I donot recommend placing unlimited risk strategies; they are included so thatreaders are introduced to the mechanics involved.

A long straddle and strangle form a U-shaped risk graph, which visu-ally conveys the unlimited reward and limited risk nature of these deltaneutral strategies. This type of risk graph is also available when trading along synthetic straddle with calls or puts. Short straddles and strangleshave an upside-down U-shaped risk graph, which tells us that the reward islimited and the risk is unlimited.

Straddles, strangles, and synthetic straddles are all delta neutralstrategies to start. Synthetic straddles can be adjusted over time, whichmakes them a favorite for many traders. New traders often do not un-derstand how simultaneously buying a put and a call can be profitable.The idea is that as a stock moves, one side of the straddle or stranglewill see a larger gain than the other side will see a loss. If the underlyingasset rises in price, the losing option can only fall to zero, whereas theprofitable option can rise indefinitely.

100


As with any strategy, a trader should view a risk graph before enteringa trade. By finding stocks that have been consolidating but have impend-ing news, a trader can see nice, relatively safer profits using straddles,strangles, and synthetic straddles.


1. Setting up a delta neutral trade requires selecting a calculated ratioof short and long positions to create an overall position delta of______________.

A. +100.

B. –100.

C. +50.

D. Zero.

2. The delta of 100 shares of stock or one futures contract equals plus orminus ______________.

A. 500.

B. 100.

C. 50.

D. Zero.

3. The delta of an option depends on its ______________.

A. Expiration date.

B. Volatility.

C. Strike price.

D. Premium.

4. Name two ways of creating a delta neutral trade with ATM options ifyou are buying 100 shares of stock.

1. _________________________________________________________

2. _________________________________________________________

5. Name two ways of creating a delta neutral trade with ATM options ifyou are selling 100 shares of stock.

1. _________________________________________________________

2. _________________________________________________________

Straddles, Strangles, and Synthetics 101


6. By purchasing futures and buying puts, a U-shaped risk graph is createdthat reflects ______________.





7. By purchasing stock and selling calls, an upside-down U-shaped riskgraph is created that reflects the trade’s ______________.





8. By selling 100 XYZ shares and buying 2 ATM calls, what kind of riskcurve are you creating?

A. U-shaped risk curve with unlimited profit potential and limited risk.

B. U-shaped risk curve with limited profit potential and unlimited risk.

C. Upside-down U-shaped risk curve with unlimited profit potentialand limited risk.

D. Upside-down U-shaped risk curve with limited profit potentialand unlimited risk.

9. By selling 100 XYZ shares and selling two ATM puts, what kind of riskcurve are you creating?

A. U-shaped risk curve with unlimited profit potential and limited risk.

B. U-shaped risk curve with limited profit potential and unlimited risk.

C. Upside-down U-shaped risk curve with unlimited profit potentialand limited risk.

D. Upside-down U-shaped risk curve with limited profit potentialand unlimited risk.

10. Buying a straddle involves buying both a call and a put with______________.

A. Different strike prices and identical expiration months.

B. Identical strike prices and different expiration months.

C. Identical strike prices and expiration months.

D. Different strike prices and expiration months.



11. To place a long straddle, it is optimal to locate a market with______________.

A. High volatility expecting a volatility decrease.

B. Low volatility expecting a volatility increase.

C. Continuous high liquidity.

D. Continuous low liquidity.

12. Long straddles create what kind of risk profiles?

A. V-shaped risk curves with unlimited profit potential and limitedrisk.

B. V-shaped risk curves with limited profit potential and unlimitedrisk.

C. Upside-down V-shaped risk curves with unlimited profit potentialand limited risk.

D. Upside-down V-shaped risk curves with limited profit potentialand unlimited risk.

13. How is the upside breakeven of a long straddle calculated?

____________________________________________________________

14. How is the downside breakeven of a long straddle calculated?

____________________________________________________________

15. Calculate the values for the following long straddle:

Long 1 November ATM DELL 35 Call @ 2.45

Long 1 November ATM DELL 35 Put @ 2.20

DELL is currently trading at $35.10.

Put cost = __________________________________________________

Call cost = __________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________

Upside breakeven = __________________________________________

Downside breakeven = _______________________________________

Range of profitability = _______________________________________



16. Short straddles create what kind of risk profiles?

A. V-shaped risk curves with unlimited profit potential and limitedrisk.

B. V-shaped risk curves with limited profit potential and unlimitedrisk.

C. Upside-down V-shaped risk curves with unlimited profit potentialand limited risk.

D. Upside-down V-shaped risk curves with limited profit potentialand unlimited risk.

17. Calculate the values for the following short straddle:

Short 1 July SMH 37.50 Call @ 1.50

Short 1 July SMH 37.50 Put @ 1.25

SMH is trading at $37.71.

Put credit = _________________________________________________

Call credit = _________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________




18. Strangles are quite similar to straddles, except ______________.

A. The options have different expiration months.

B. One option is short and the other is long.

C. The options are ITM instead of ATM.

D. The options are OTM instead of ATM.

19. Long strangles involve buying both an OTM call and an OTM putwith ______________.

A. Different strike prices and identical expiration months.

B. Identical strike prices and different expiration months.

C. Identical strike prices and expiration months.

D. Different strike prices and expiration months.



20. A long strangle has ______________________________________.

A. Limited profit potential and limited risk.

B. Limited profit potential and unlimited risk.

C. Unlimited profit potential and unlimited risk.

D. Unlimited profit potential and limited risk.

21. Calculate the values for the following long strangle example:

Long 1 November DELL 40 Call @ 0.65

Long 1 November DELL 30 Put @ 0.70


Put cost = __________________________________________________

Call cost = __________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________




22. True or False: Fixed straddles can be adjusted as the market movesback and forth.

23. Name two ways of creating a long synthetic straddle using a stock.

1. _________________________________________________________

2. _________________________________________________________

24. Calculate the values for the following long synthetic straddle example:

Long 100 Shares of DELL @ $35.10

Long 2 November DELL 35 Puts @ 2.20

Stock cost = _________________________________________________

Put cost = ___________________________________________________



Maximum reward = __________________________________________

Maximum risk = _____________________________________________





Short 100 Shares of DELL @ $35.10

Long 2 November DELL 35 Calls @ 6.85

Stock cost = _________________________________________________

Call cost = __________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________




MEDIA ASSIGNMENT

Delta neutral strategies take away the necessity to predict market direc-tion. However, we still need to find stocks that are expected to showvolatility and to choose options with low implied volatility. For this mediaassignment, identify several securities that are good candidates for deltaneutral strategies. Before entering the data into the Optionetics Platinumsite, take the time to manually calculate the details of the trade, includingthe breakeven points, maximum risk and profit, and the range of prof-itability. After you have calculated this data, plug it into Optionetics Plat-inum (or some other options program) and see if your calculations arecorrect. As an added bonus, check out the risk graphs as well. Comparethe risk graphs for various strategies, including straddles, strangles, andlong synthetic straddles.



VOCABULARY LIST

SOLUTIONS

1. Setting up a delta neutral trade requires selecting a calculated ratioof short and long positions to create an overall position delta of______________.

Answer: D—Zero.

Discussion: The idea with a delta neutral trade is to get the overalldelta as close to zero as possible. Of course, there will be trades thathave slightly positive or negative deltas, but this doesn’t mean theywon’t have a similar risk graph to a perfectly delta neutral trade.

2. The delta of 100 shares of stock or one futures contract equals plus orminus ______________.

Answer: B—100.

Discussion: Unlike options, futures and stocks do not have frac-tional deltas. They have deltas equal to 1.00. This allows a trader toset up strategies that incorporate options, stock, and/or futures to create delta neutral strategies. Obviously, if we buy 100 shares of stock and sell 100 shares of the same stock, there is no way to make a profit. However, by creating synthetic positions, we can make a profit using options without needing to predict marketdirection.

3. The delta of an option depends on its ______________.

Answer: C—Strike price.

Discussion: One definition of delta is that it tells the trader the odds ofan option finishing in-the-money by expiration. Thus, the farther awaythe option strike is from the stock price (in the unprofitable direction),


Average Directional MovementIndex (ADX)

Delta

Delta neutral trade

Long straddle

Long strangle

Long synthetic straddle

Risk graph

Straddle

Strangle


the lower the delta. In-the-money options have deltas generally above50, while out-of-the-money options have deltas below 50.

4. Name two ways of creating a delta neutral trade with ATM options ifyou are buying 100 shares of stock.

Answer: Buy two ATM puts or sell two ATM calls.

Discussion: One hundred shares of stock equals +100 deltas, so weneed to create a combination of options that equal –100 deltas. Theeasiest way to create –100 deltas is to sell two ATM calls or to buytwo ATM puts. Though the delta might not be exactly –100, usingATM options will make the delta close enough to this figure.

5. Name two ways of creating a delta neutral trade with ATM options ifyou are selling 100 shares of stock.

Answer: Buy two ATM calls or sell two ATM puts.

Discussion: To offset –100 deltas that comes from selling the stock,you can buy two ATM calls or sell two ATM puts to bring in +100delta. The idea is that anything bullish creates a positive delta andanything bearish creates a negative delta.

6. By purchasing futures and buying puts, a U-shaped risk graph is cre-ated that reflects ______________.


Discussion: This is the optimal type of risk graph delta neutraltraders like to see. Though not all options strategies are created withunlimited reward and limited risk, this is what we strive to achieve.

7. By purchasing stock and selling calls, an upside-down U-shaped riskgraph is created that reflects the trade’s ______________.

Answer: B—Limited profit potential with unlimited risk.

Discussion: An upside-down U is exactly the opposite of whatdelta neutral traders want to see, as it shows unlimited risk and lim-ited profits. Though this type of trade might be profitable most ofthe time, it takes only one trade that goes wrong to erase an entiretrading account.

8. By selling 100 XYZ shares and buying two ATM calls, what kind ofrisk curve are you creating?

Answer: A—U-shaped risk curve with unlimited profit potential andlimited risk.



Discussion: This position is called a long synthetic straddle usingcalls. The U shape is created because the trade profits on a sharpmove lower or a sharp move higher. If the stock stays flat, then a losswould most likely be incurred.

9. By selling 100 XYZ shares and selling two ATM puts, what kind of riskcurve are you creating?

Answer: D—Upside-down U-shaped risk curve with limited profitpotential and unlimited risk.

Discussion: This trade is a short synthetic straddle using puts. Byselling both the stock and the puts, the maximum profit is the creditreceived from selling the puts and stock. However, if the underlyingmoves sharply in either direction, a large loss can be incurred.

10. Buying a straddle involves buying both a call and a put with______________.

Answer: C—Identical strike prices and expiration months.

Discussion: Composed of both a long ATM call and a long ATM put, astraddle makes money when the underlying asset moves sharply in ei-ther direction. As the stock moves higher, the call increases in valuefaster than the put loses money. The opposite also holds true, with adecline in the stock’s price increasing the value of the put faster thanthe loss incurred in the call.

11. To place a long straddle, it is optimal to locate a market with______________.

Answer: B—Low volatility expecting a volatility increase.

Discussion: A long straddle consists of buying two options. Impliedvolatility has a major impact on the price of an option, so we want tobuy options that have historically low IV. This puts the odds of suc-cess higher for a straddle trader. Straddle traders also want to see avolatility increase because this means a larger move in the underly-ing security.

12. Long straddles create what kind of risk profiles?

Answer: A—V-shaped risk curves with unlimited profit potential andlimited risk.

Discussion: Just like a long synthetic straddle, a straddle has unlim-ited profit potential and limited risk. This is what we are looking forwhen we enter a delta neutral trade.



13. How is the upside breakeven of a long straddle calculated?

Answer: Upside breakeven = strike price + net debit.

Discussion: The upside breakeven at expiration is calculated byadding the net debit required to enter the trade to the strike price.However, this doesn’t mean that a profit can’t be made before expira-tion on a smaller move if volatility increases in magnitude.

14. How is the downside breakeven of a long straddle calculated?

Answer: Downside breakeven = strike price – net debit.

Discussion: The downside breakeven at expiration is calculated bysubtracting the net debit required to enter the trade from the strikeprice. However, this doesn’t mean that a profit can’t be made beforeexpiration on a smaller move if volatility increases in magnitude. Youwill rarely hold a straddle until expiration, anyway.

15. Calculate the values for the following long straddle:

Long 1 November ATM DELL 35 Call @ 2.45

Long 1 November ATM DELL 35 Put @ 2.20


Answer:

Put cost = 2.20 or $220.

Call cost = 2.45 or $245.

Maximum reward = Unlimited to the upside and limited to the down-side (as the underlying can only fall to zero) beyond the breakevens.

Maximum risk = (2.45 + 2.20) × 100 = $465 (Total debit).

Upside breakeven = (35 + 4.65) = $39.65 (Call strike + net debit).

Downside breakeven = (35 – 4.65) = $30.35 (Put strike – net debit).

Range of profitability = Above $39.65 and below $30.35.

Discussion: The breakeven points, maximum risk and reward, andtotal costs are important values to understand before entering atrade. These values can be figured manually, or you can use a pro-gram like Optionetics Platinum to calculate these details. Either way,it is very important to assess a trade’s risks before jumping in andputting real money on the line.

16. Short straddles create what kind of risk profiles?

Answer: D—Upside-down V-shaped risk curves with limited profitpotential and unlimited risk.



Discussion: A short straddle or strangle creates an upside-down V-shaped risk graph. This is not the kind of risk profile that a deltaneutral trader wants to see. Though this type of trade might have ahigh winning percentage in sideways-moving markets, it takes onlyone sharp move to wipe out a trading account.

17. Calculate the values for the following short straddle:

Short 1 July SMH 37.50 Call @ 1.50

Short 1 July SMH 37.50 Put @ 1.25

SMH is trading at $37.71.

Answer:

Put credit = 1.25 or $125.

Call credit = 1.50 or $150.

Maximum reward = (1.25 + 1.50) × 100 = $275 (Limited to the netcredit).

Maximum risk = Unlimited to the upside and limited to the downside(as the underlying can only fall to zero) beyond the breakevens.

Upside breakeven = (37.50 + 2.75) = $40.25 (ATM strike price + netcredit).

Downside breakeven = (37.50 – 2.75) = $34.75 (ATM strike price – netcredit).

Range of profitability = Between $34.75 and $40.25.

18. Strangles are quite similar to straddles, except ______________.

Answer: D—The options are OTM instead of ATM.

Discussion: Strangles have a similar risk profile to a straddle, exceptthat the maximum loss area is wider. However, the initial cost to en-ter a strangle is lower. Keep in mind that the underlying asset has tomake a larger move for the trade to become profitable.

19. Long strangles involve buying both an OTM call and an OTM put with______________

Answer: A—Different strike prices and identical expiration months.

Discussion: By using OTM options, the trader’s cost to enter a stran-gle is less than the cost to enter a straddle. However, because the op-tions are OTM, the underlying security has to see a larger move togarner a profit.



20. A long strangle has ______________.

Answer: D—Unlimited profit potential and limited risk.

Discussion: Just like a straddle, a strangle has limited risk and un-limited profit potential. The main difference is that there is a widerarea between the two strike prices where the maximum loss is in-curred. Whether to use a straddle or a strangle is a personal decisionand should be based on the outlook for the stock and the risk graph.

21. Calculate the values for the following long strangle example:

Long 1 November DELL 40 Call @ 0.65

Long 1 November DELL 30 Put @ 0.70


Answer:

Put cost = 0.70 or $70.

Call cost = 0.65 or $65.

Maximum reward = Unlimited to the upside and downside beyondthe breakevens.

Maximum risk = (.70 + .65) × 100 = $135 (Total debit).

Upside breakeven = (40 + 1.35) = $41.35 (Call strike + net debit).

Downside breakeven = (30 – 1.35) = $28.65 (Put strike – net debit).


Discussion: The cost to enter a strangle is lower than the cost of astraddle. However, by comparing the straddle and strangle example,we can see that a strangle takes a much larger move to break evenand make a profit. The maximum risk area is also much larger, fallingbetween the two breakevens. A straddle sees a maximum loss only ifthe underlying closes right on the ATM strike price.

22. True or False: Fixed straddles can be adjusted as the market movesback and forth.

Answer: False.

Discussion: Fixed straddles cannot be adjusted. If you want to beable to make adjustments as the trade progresses, then look at usinglong synthetic straddles.

23. Name two ways of creating a long synthetic straddle using a stock.

Answer:

1. Sell 100 shares and buy two ATM calls.

2. Buy 100 shares and buy two ATM puts.



Discussion: A long synthetic straddle is a delta neutral trade thatconsists of shares of stock against long options. A long syntheticstraddle with multiple contracts can be adjusted back to delta neutralas the trade progresses. The risk profile is similar to a straddle buthas a U-shaped risk curve instead of a V-shaped one. A trader doesn’tneed to use ATM options, but this is the easiest way to create a longsynthetic straddle.


Long 100 Shares of DELL @ $35.10

Long 2 November DELL 35 Puts @ 2.20

Answer:

Maximum reward = Unlimited.

Maximum risk = [(2 × 2.20) + (35.10 – 35)] × 100 = $450 {Net debit ofoptions + [(Price of underlying stock at initiation – option strikeprice) × number of shares]}.

Upside breakeven = (35.10 + 4.40) = $39.50 (Price of underlying stockat initiation + net debit of options).

Downside breakeven = [(2 × 35) – 35.10] – 4.40 = $30.50 {[(2 × optionstrike) – price of underlying stock at initiation] – net debit of options}.


Discussion: The breakeven points take a little more calculating be-cause the stock price isn’t exactly at $35. Though this calculationcan still be made manually, it is much easier to use a program likeOptionetics Platinum.


Short 100 Shares of DELL @ $35.10

Long 2 November DELL 35 Calls @ 6.85

Answer:

Maximum reward = Unlimited.

Maximum risk = [(2 × 6.85) + (35 – 35.10)] × 100 = $1,360 {[Net debitof options + (option strike – price of underlying at initiation)] × num-ber of shares.

Upside breakeven = [(2 × 35) – 35.10] + 13.70) = $48.60 {[(2 × optionstrike) – price of underlying stock at initiation] + net debit of options}.



Downside breakeven = 35.10 – 13.70 = $21.40 (Price of underlyingstock at initiation – net debit of options).

Range of profitability = Below $21.40 and above $48.60.

Discussion: By comparing the risk graphs and different variables, atrader can decide whether to short shares and buy calls or to buyshares and buy puts to create a long synthetic straddle. Ultimately,we want to enter the trade that provides the best reward-to-risk ratio.

MEDIA ASSIGNMENT

Although there are computer programs that will generate risk graphs andthe details of a particular options strategy, it is very helpful to understandhow these details are figured manually. In doing this media assignment,not only should you gain a better understanding of the risks of a trade, butyou’ll appreciate how a computer speeds up the process.


Average Directional Movement Index (ADX): An indicator developedby J. Welles Wilder to measure market trend intensity. It does not give sig-nals regarding direction, but tells traders whether the stock or index is inthe midst of a healthy trend (either up or down). The idea is for direc-tional traders to stay out of choppy or sideways markets (i.e., when thestock or index is not trending), and commit to the markets only when thestock or index is moving within a clear trend.


Delta neutral trade: This is an options/options or options/underlying in-strument position constructed so that it is relatively insensitive to theprice movement of the underlying instruments. This is arranged by select-ing a calculated ratio of short and long positions with a combined positiondelta of zero.

Long straddle: A non-directional option strategy that combines the si-multaneous purchase of the same number of ATM puts and calls withidentical expirations. The maximum loss is limited to the net debit ofthe options. The upside breakeven is equal to the net debit plus thestrike price, and the downside breakeven is calculated by subtractingthe net debit from the strike price. The maximum profit is unlimited to



the upside and limited to the downside (as the underlying can only fallto zero) beyond the breakevens.

Long strangle: The purchase of an OTM call and an OTM put with thesame expiration date. Look for a stable market where you anticipate alarge volatility spike. The maximum risk is limited to the net debit paid.The maximum profit is unlimited to the upside and limited to the down-side (as the underlying can only fall to zero) beyond the breakevens. Theupside breakeven is calculated by adding the call strike to the net debit,and the downside breakeven is calculated by subtracting the net debitfrom the put strike.

Long synthetic straddle: A delta neutral trade in which two long op-tions are balanced out by 100 shares of stock. Look for a market with lowvolatility where you anticipate a volatility increase resulting in stock pricemovement in either direction beyond the breakevens.

Risk graph: A graphical representation of risk and reward on any giventrade.

Straddle: A position consisting of a long (or short) call and a long (orshort) put, where both options have the same strike price and expira-tion date.

Strangle: A position that consists of a long (or short) OTM call and a long(or short) OTM put where both options have the same underlying andsame expiration date, but different strike prices.



CHAPTER 9

AdvancedDelta Neutral

Strategies

SUMMARY

Most successful options traders are continuously accessing risk-rewardprobabilities. Trades that offer limited rewards but high risks are often ill-advised. Instead, experienced strategists tend to focus on situations thatoffer high rewards and limited risks. In order to find these more attractivescenarios, traders work to develop more complex strategies and study theprobabilities of success or failure using risk graphs.

In this chapter, the reader is introduced to four advanced delta neu-tral strategies: ratio call spreads, ratio put spreads, call ratio backspreadsand put ratio backspreads. These strategies are a bit more complex andinvolve simultaneously buying and selling either puts or calls in differentquantities. For example, ratio spreads involve either all puts or all callsand are established by purchasing a put or call and selling a greater num-ber of puts or calls. Ratio spreads provide a wide profit zone, but comewith unlimited risk. Ratio backspreads, on the other hand, involve sellingone or more options (puts or calls) and buying a greater number of op-tions (puts or calls). Ratio backspreads are generally initiated as credittrades and offer limited risk with unlimited reward potential, which is theoptional type of situation for experienced options traders.


1. A ratio spread is a strategy in which an ______________ number of op-tion contracts of the same underlying instrument are bought and sold.

116


A. Even.

B. Uneven.

2. A ratio call spread involves ______________.

A. Buying a lower strike option and selling a greater number of ITMoptions.

B. Buying a higher strike option and selling a greater number ofATM options.

C. Buying a lower strike option and selling a greater number of OTMoptions.

D. Buying a higher strike option and selling a greater number ofOTM options.

3. Calculate the values for the following ratio call spread:

Long 1 January QQQ 37 Call @ 2.50

Short 2 January QQQ 40 Calls @ 1.50

Net credit = _________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________


4. A ratio call spread should be implemented in a/an ______________market.

A. Bullish.

B. Bearish.

C. Either bullish or bearish.

5. A ratio put spread involves ______________.

A. Buying a higher strike put option and selling a greater number ofOTM put options.

B. Buying a lower strike put option and selling a greater number ofOTM put options.

C. Buying a higher strike put option and selling a greater number ofITM put options.

D. Buying a lower strike put option and selling a greater number ofITM put options.

Advanced Delta Neutral Strategies 117


6. Calculate the values for the following ratio put spread:

Long 1 January QQQ 35 Put @ 2.00

Short 2 January QQQ 32 Puts @ 1.25

Net credit = _________________________________________________

Maximum profit = ____________________________________________

Maximum risk = _____________________________________________


7. A ratio put spread should be implemented in a/an ______________market.

A. Bullish.

B. Bearish.

C. Either bullish or bearish.

8. True or False: Never attempt to place a ratio backspread in a marketwith low volatility.

9. A call ratio backspread involves ______________.

A. Selling a higher strike call and buying a greater number of lowerstrike calls.

B. Selling a lower strike call and buying a greater number of higherstrike calls.

C. Buying a higher strike call and selling a greater number of lowerstrike calls.

D. Buying a lower strike call and selling a greater number of higherstrike calls.

10. Calculate the values for the following call ratio backspread:


Long 3 January QQQ 38 Calls @ 2.25

Net credit = _________________________________________________

Maximum profit = ____________________________________________

Maximum risk = _____________________________________________





11. Call ratio backspreads are best implemented during periods of______________.

A. High volatility in a highly volatile market that shows signs ofincreasing activity to the upside.

B. High volatility in a highly volatile market that shows signs ofincreasing activity to the downside.

C. Low volatility in a highly volatile market that shows signs of increasing activity to the upside.

D. Low volatility in a highly volatile market that shows signs of increasing activity to the downside.

12. Put ratio backspreads are best implemented during periods of______________.

A. High volatility in a highly volatile market that shows signs ofincreasing activity to the upside.

B. High volatility in a highly volatile market that shows signs ofincreasing activity to the downside.

C. Low volatility in a highly volatile market that shows signs of increasing activity to the upside.

D. Low volatility in a highly volatile market that shows signs of increasing activity to the downside.

13. A put ratio backspread involves ______________.

A. Selling a higher strike put and buying a greater number of lowerstrike puts.

B. Selling a lower strike put and buying a greater number of higherstrike puts.

C. Buying a higher strike put and selling a greater number of lowerstrike puts.

D. Buying a lower strike put and selling a greater number of higherstrike puts.

14. Calculate the values for the following put ratio backspread:


Long 3 January QQQ 32 Puts @ 1.25

Net credit /debit = ____________________________________________

Maximum profit = ____________________________________________



Maximum risk = _____________________________________________



15. What is the difference between a forward and a reverse volatilityskew?

____________________________________________________________

____________________________________________________________

MEDIA ASSIGNMENT

In Chapter 4, the media assignment used the free options calculator fromthe Chicago Board Options Exchange web site at www.cboe.com to cre-ate a risk curve for the long call. Let’s go back to that calculator and re-peat the process using a more complex strategy. So, from the CBOE homepage, click on the “Trading Tools” tab and then the “Volatility Optimizer”and then click on “Options Calculator.” Next, select “American” in thestyle box. (Note: If, for some reason the CBOE site is not available, read-ers can use any online options calculator to complete this assignment.)

Start by creating a table with the following column heads: stock price,long call price, value of two long calls, value of short call, and overall posi-tion value. Then, on a piece of graph paper (or using a Microsoft Excelprintout), create a risk graph by drawing a horizontal axis and a verticalaxis. Along the horizontal axis, write the numbers 60, 65, 70, 75, 80, 85,and 90 at evenly spaced intervals. From bottom to top, write the numbers–5, –4, –3, –2, –1, 0, 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10 along the vertical axis.

Using the chart and the options calculator, let’s create a risk curve fora call ratio backspread. In this example, the call ratio backspread involvesselling an at-the-money call option and buying two out-of-the-money op-tions. Let’s use the strike prices of 65 and 75.

Now input some variables into the calculator regarding the long calls.First, let the strike price equal 75; the volatility is 30 percent, the annualinterest rate is 5 percent, and the company pays no dividend (quarterlydividend amount equals 0). Next, in the “Days Left to Expiration” box,click “Days Until Expiration” and enter the number 100. We are going tobuy two long calls that have 100 days remaining until expiration, a strikeprice of 75, volatility of 30 percent, and an underlying security that paysno dividends. At the same time, we will sell short one call with a strikeprice of 65, 100 days left until expiration, and volatility of 30 percent.



Now, let’s look at the position as the stock price changes. Enter 60into the “Equity Price” box and look at the value of the long call. It has avalue of 45 cents. Since there are two long calls in this trade, the totalvalue of the long calls is 90 cents. Now, the short call is worth $2.20. So,the value of the position is –$1.30. Put a dot on the risk graph where theposition value equals –$130 and the stock price equals 60. Now, repeatthe calculation for the stock prices 70 through 90. When you reach the fi-nal equity price value of 90, the long call is worth roughly $1,650 a con-tract and the two long calls equal $3,300. The short call is worth $2,600 acontract. Subtract the value of the short call from the long calls and thecall ratio backspread is worth $7. Finally, connect the dots and you havejust created a risk curve for this trade. It is U-shaped, but also upwardsloping to the right. (Note: In practice, the risk curve will look a bit dif-ferent than the one drawn in this example because we have not factoredin the credit received or premium paid for the trade. Nevertheless, therisk curve of any call ratio backspread will take on a shape similar to theone drawn here.)

VOCABULARY LIST

SOLUTIONS

1. A ratio spread is a strategy in which an ______________ number ofoption contracts of the same underlying instrument are bought and sold.

Answer: B—Uneven.

Discussion: To create a ratio spread, the strategist will sell one ormore at-the-money or near-the-money options and sell a greater num-ber of out-of-the-money contracts. The trade can be created usingeither puts or calls.


Call ratio backspread

Forward volatility skew

Nondirectional

Price skew

Put ratio backspread

Ratio backspread

Ratio call spread

Ratio put spread

Ratio spread

Reverse volatility skew

Time skew

Volatility skew


2. A ratio call spread involves ______________.

Answer: C—Buying a lower strike option and selling a greaternumber of OTM options.

Discussion: As the name implies, the ratio call spread is establishedwith call options. The strategist will buy one or more calls and sell agreater number of calls with a higher strike price. Common ratiosinclude 1-to-2 and 2-to-3.

3. Calculate the values for the following ratio call spread:

Long 1 January QQQ 37 Call @ 2.50


Answer:

Net credit = [(2 × 1.50) – 2.50] × 100 = $50 [(Short – long premium)× 100].

Maximum reward = [1 × (40 – 37) + .50] × 100 = $350 [Number of longcontracts × (difference in strikes + net credit)] × 100.

Maximum risk = Unlimited to the upside above the breakeven.

Upside breakeven = 37 + [(40 – 37) × 2 ÷ (2 – 1)] + .50 = $43.50 {Lowerstrike + [(difference in strikes × number of short contracts) ÷ (num-ber of short calls – number of long calls)] + net credit}.

Discussion: The credit received for the ratio call spread equals thepremium received from the sale of the calls minus the premium paidfor the purchase of the call(s) with the lower strike price(s). In thiscase, it equals $3.00 minus $2.50, or $50 per contract. The maximumreward occurs if both short calls expire worthless and the long callis closed at or near expiration for a profit. In this case, the premiumkept from the long calls if the QQQ reaches exactly $40 equals $300.At that point, the long call yields a $50 profit and the maximum gainis therefore $350.

4. A ratio call spread should be implemented in a/an ______________market.

Answer: B—Bearish.

Discussion: The ratio call spread is best established when the strate-gist expects the underlying asset to move only modestly higher, re-main unchanged, or fall in price. The idea is to keep the optionpremiums from the short calls, so a bullish move in the underlyinginstrument would result in losses.



5. A ratio put spread involves ______________.

Answer: A—Buying a higher strike put option and selling a greaternumber of OTM put options.

Discussion: The ratio put spread is similar to the ratio call spread.However, as the name suggests, the strategy uses puts instead ofcalls. In addition, the strategist is buying one or more put options andselling a greater number of puts with a lower strike price.

6. Calculate the values for the following ratio put spread:

Long 1 January QQQ 35 Put @ 2.00


Answer:

Net credit = [(2 × 1.25) – 2] × 100 = $50 [(Short – long premium) × 100].

Maximum profit = [(35 – 32) + .50] × 100 = $350 [(Difference in strikeprices + net credit) × 100].

Maximum risk = Limited to the downside until the underlying falls tozero ($2,850 is then the maximum loss).

Downside breakeven = 35 – [(35 – 32) × 2) ÷ (2 – 1)] – .50 = $28.50{Higher strike – [(difference in strike prices × number of short con-tracts) ÷ (number of short contracts – number of long contracts)] –net credit}.

Discussion: The credit from the ratio put spread is equal to the pre-mium received minus the premium paid, which, in this case, equals$2.50 minus $2.00, or $.50 per spread. The maximum profit occurs ifthe short options expire worthless but the long put increases in valueas much as possible. At $32 a share at expiration, the short puts willexpire worthless, but the long put will be worth $300. Therefore, thetrader keeps all of the premium from the short puts, or $2.50, andmakes another $1 profit on the long put. At that point, the maximumprofit is $350. However, the risks are considerable and the maximumloss of $2,850 will occur if the underlying instrument falls to zero.

7. A ratio put spread should be implemented in a/an ______________market.

Answer: A—Bullish.

Discussion: If the underlying asset makes a sharp drop, the ratio putspread will result in losses. For that reason, it is best establishedwhen the trader is bullish on the underlying instrument and expectsto see a significant move higher or only a modest move lower.



8. True or False: Never attempt to place a ratio backspread in a marketwith low volatility.

Answer: False.

Discussion: Placing ratio backspreads in markets with low volatilityis not recommended. However, if you do choose to trade a slow mar-ket, follow these three rules: (1) Use a .75 ratio or higher, (2) buy thelower strike, and (3) sell the higher strike.

9. A call ratio backspread involves ______________.

Answer: B—Selling a lower strike call and buying a greater numberof higher strike calls.

Discussion: The call ratio backspread is established using call options.The strategist will simultaneously sell one or more calls and buy agreater number of calls with the same expiration date. Ratios of 1-to-2or 2-to-3 are commonly used.

10. Calculate the values for the following call ratio backspread:


Long 3 January QQQ 38 Calls @ 2.25

Answer:

Net credit = [(2 × 4) – (3 × 2.25)] × 100 = $125 [(Short – long premium)× 100].

Maximum profit = Unlimited above the upside breakeven.

Maximum risk = [2 × (38 – 35) – 1.25] × 100 = $475 {[(Number of shortcalls × difference in strikes) – net credit] × 100}.

Upside breakeven = 38 + [(38 – 35) × 2] ÷ (3 – 2) – 1.25 = $42.75{Higher strike + [(difference in strikes × number of short calls) ÷(number of long calls – number of short calls)] – net credit}.

Downside breakeven = 35 + 1.25 = $36.25 (Short strike + net credit).

Discussion: The credit received, or debit paid, in a call ratio back-spread equals the premium of the short options minus the premiumfor the long options—in this case, $8.00 minus $6.75, or $125 perspread. The maximum profit is unlimited as the stock moves higher. Acall ratio backspread is best placed in a market where you anticipatea sharp rise with increasing volatility.

11. Call ratio backspreads are best implemented during periods of______________.

Answer: C—Low volatility in a highly volatile market that showssigns of increasing activity to the upside.



Discussion: The call ratio backspread yields the greatest profitswhen the underlying instrument makes a significant move higher. If,however, the underlying instrument falls sharply, the strategist cankeep the initial net credit. For that reason, it is best established for acredit, and this can usually be accomplished when volatility is low.

12. Put ratio backspreads are best implemented during periods of______________.

Answer: D—Low volatility in a highly volatile market that showssigns of increasing activity to the downside.

Discussion: The put ratio backspread is a bearish strategy that gen-erates the most profits when the underlying security makes an explo-sive move to the downside.

13. A put ratio backspread involves ______________.

Answer: A—Selling a higher strike put and buying a greater numberof lower strike puts.

Discussion: The ratio put backspread is established by purchasingone or more puts and selling a greater number of puts with a lowerstrike price with the same expiration date. Ratios of 1-to-2 or 2-to-3are often used to establish backspreads.

14. Calculate the values for the following put ratio backspread:


Long 3 January QQQ 32 Puts @ 1.25

Answer:

Net credit = [(2 × 2.50) – (3 × 1.25)] × 100 = $125 [(Short – long pre-mium) × 100].

Maximum profit = $2,725 (Limited to the downside as the underlyingfalls to zero).

Maximum risk = [2 × (35 – 32)] – 1.25 × 100 = $475 [(Number of shortputs × difference in strikes) – net credit] × 100.

Upside breakeven = (35 – 1.25) = $33.75 (Higher strike – net credit).

Downside breakeven = 32 – [2 × (35 – 32) ÷ (3 – 2)] + 1.25 = $27.25{Lower strike – [(number of short puts × difference in strikes) ÷(number of long puts – number of short puts)] + net credit}.

Discussion: The net credit (or net debit) from the put ratio back-spread is equal to the premium received minus the premium paid. Ifthe underlying instrument rallies, the strategist can let the puts expire



worthless and keep the net credit. The maximum profit, however, oc-curs if the underlying asset falls sharply. In this case, the maximumprofit is equal to $2,725. The maximum risk, meanwhile, is limited andequal to the difference in the strike prices times the number of shortoptions minus the net credit.

15. What is the difference between a forward and a reverse volatility skew?

Answer: With a forward price skew, the options with the higherstrike prices have higher implied volatility than the options withlower strike prices. The reverse volatility skew, in contrast, will havehigher implied volatility in the lower strike prices when compared tothe higher strike prices.

Discussion: Ratio backspreads and other types of vertical spreads cantake advantage of volatility skews. For example, with a forward skew,strategists can sell the options with the higher strike price and buythose with the lower strike price. On the other hand, strategists can buythe higher strike price and sell the lower one if a reverse volatility skewexists. The type of spread, and whether to use puts or calls, will dependon the outlook for the underlying asset. For instance, if a contract has areverse skew and the strategist is bullish on the underlying asset, a callratio backspread might be the appropriate strategy to employ.

MEDIA ASSIGNMENT

In this chapter, we once again use the free options calculator at theChicago Board Options Exchange web site to create a risk curve (in Chap-ter 4 we created a curve for the long call). This chapter’s example focuseson the call ratio backspread. Before plotting the graph, the reader shouldhave generated a table similar to the one shown.

Value of Two Value ofStock Price Long Call Price Long Calls Short Call Position Value

60 0.45 0.90 2.20 –1.30

65 1.25 2.50 4.50 –2.00

70 2.80 5.60 7.80 –2.20

75 5.15 10.30 11.80 –1.50

80 8.40 16.80 16.25 0.55

85 12.30 24.60 21.00 3.60

90 16.50 33.00 26.00 7.00



After creating the table, plotting the risk curve is relatively straight-forward. We plot the coordinates where the stock price (first column)and the value of the options trade (last column) intersect. For instance,when the stock price equals $85, the value of the call ratio backspreadequals $3.60. Once all eight coordinates are plotted on the risk curve,connect the dots and the risk curve should look like the one shown inthe figure.


Call ratio backpread: A spread that involves selling a call and buying agreater number of calls with a higher strike price and the same expirationmonth.

Forward volatility skew: A type of volatility skew in which the optionwith the higher strike price has a higher implied volatility than the optionwith the lower strike price.

Nondirectional: A type of options strategy that will profit whether theunderlying asset moves higher or lower. Its success does not depend on amove in a specific direction. Straddles and strangles are examples ofnondirectional trades.

Price skew: A type of volatility skew where options with the same ex-piration date, but different strike prices, have different levels of impliedvolatility.


109876543210

–1–2–3–4–5

60 65 70 75 80 85 90

Call Ratio Backspread Risk Curve


Put ratio backspread: A strategy that involves selling a put option andbuying a greater number of put options with a lower strike price. Theexpiration dates of all the put options are the same.

Ratio backspread: A spread in which more options are purchased thansold and where all options have the same underlying and expiration date,but different strike prices.

Ratio call spread: A spread strategy that involves buying a call andselling a greater number of calls with a lower strike price and the sameexpiration date.

Ratio put spread: A strategy of buying put options and selling agreater number of put options with the same expiration date but alower strike price.

Ratio spread: A strategy that involves buying and selling options (all putsor all calls) with the same expiration date, but different strike prices. Thenumber of long contracts and short contracts are not equal.

Reverse volatility skew: A type of volatility skew where options thathave the same expiration date have higher implied volatility among thelower strike prices when compared to the higher strike prices.

Time skew: A type of skew where options that have the same strikeprices, but different expiration dates, have vastly different levels of implied volatility.

Volatility skew: When options on the same underlying asset but withdifferent strike prices and/or expiration dates have different levels ofimplied volatility. One of the most common volatility skews occurs whenthe short-term options have a much higher level of implied volatilitycompared to the longer-term options.



CHAPTER 10

TradingTechniques forRange-Bound

Markets

SUMMARY

Sometimes the markets just don’t move much. For many traders, the lackof direction or volatility can prove frustrating. After all, if markets aremoving sideways, how can a trader generate profits from bullish or bearishstrategies? Straddles and strangles won’t work very well, either, as they re-quire significant movement to cover the costs of the double option pre-mium. Fortunately, there are a few options strategies that can generateprofits in sideways-moving markets.

This chapter explores some of the strategies that can deliver profitswhen the underlying instrument trades quietly and without much move-ment. These approaches take advantage of the fact that options are wast-ing assets and lose value with the passage of time. Examples include thelong butterfly, long condor, and the long iron butterfly, as well as calendarspreads and collars. These strategies can be used to profit from time decayand thus can help options traders generate profits even in low-volatility orrange-bound markets.

Although the real excitement in trading may come from jumping ona big trend and watching your chosen stock double every month or youroptions double or triple by the end of the week, in the real world thatseldom happens. If you accept the fact that the majority of stocks arenot going to move significantly from month-to-month, you can makeconsistent, although modest, profits using sideways strategies. Andsince the risk is defined, you will not take on any more risk than is acceptable to you.

129



1. In sideways markets, option strategies can be developed to takeadvantage of ______________.

A. Gamma decay.

B. Theta decay.

C. Delta neutrality.

D. Vega neutrality.

2. A sideways market is a market that ______________.

A. Has extremely low volatility.

B. Moves erratically.

C. Stays between consistent resistance and support levels.

D. Stays at the same market volume consistently.

3. Name the three parts of a butterfly strategy.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

4. The body of a butterfly spread contains ______________.

A. An option with the strike price above the resistance level.

B. An option with the strike price below the support level.

C. An option with the strike price outside of the support and resis-tance levels.

D. An option with the strike price in between the support and resis-tance levels.

5. The wings of a butterfly spread are comprised of ______________.

A. Options with the strike prices outside of the trading range.

B. Options with the strike prices at both ends of the trading range.

C. Options with the strike prices close to the equilibrium level.

D. One option outside the support level and one inside the resis-tance level.



6. A long butterfly spread consists of ______________.

A. Going long (buying) the wings and going short (selling) the body(the middle strike options).

B. Going long (buying) the wings and going long (buying) the body(the middle strike options).

C. Going short (selling) the wings and going long (buying) the body(the middle strike options).

D. Going short (selling) the wings and going short (selling) the body(the middle strike options).

7. Money is made on a long butterfly when the market closes______________.

A. Outside of the wings.

B. In-between the wings.

8. Calculate the values for the following long butterfly trade:


Short 2 December IBM 85 Calls @ 5.00


IBM is currently trading at $85.

Net debit = __________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________



9. In a long condor, you need to ______________.

A. Go long the two inner option strikes of the body and go long thewings.

B. Go long the two inner option strikes of the body and go short thewings.

C. Go short the two inner option strikes of the body and go long thewings.

D. Go short the two inner option strikes of the body and go short thewings.

Trading Techniques for Range-Bound Markets 131


10. Calculate the values for the following long condor trade:

Long 1 MSFT December 60 Call @ 8.00

Short 1 MSFT December 65 Call @ 5.00



Net debit = __________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________



11. A long iron butterfly is a combination of ________________________.

A. A bear put spread and a bull put spread.

B. A bear call spread and a bull call spread.

C. A bear call spread and a bull put spread.

D. A bear put spread and a bull call spread.

12. Calculate the values for the following long iron butterfly trade:

Long 1 EBAY January 75 Call @ $2.50

Short 1 EBAY January 70 Call @ $5.00

Short 1 EBAY January 65 Put @ $2.00

Long 1 EBAY January 60 Put @ $1.00

Net credit = _________________________________________________

Maximum reward = __________________________________________

Maximum risk = _____________________________________________



13. A calendar spread is a combination of __________________________.

A. A long option and a short option.

B. A covered call and a protective put.



14. A diagonal spread is a combination of ______________.



15. A collar strategy is a combination of ______________.



MEDIA ASSIGNMENT

In this chapter, we are going to look for stocks that are trading sidewaysor within a range. In order to do so, connect to the Internet with yourbrowser set on www.optionetics.com. At that point, you’ll see the “FreeRanker” on the Optionetics home page. At the time of this writing, it islocated near the bottom right-hand side of the web site.

Using the free ranker, you want to look for range-bound stocks. In thiseffort, you can click on the button that says “Quiet.” These stocks are theones that have less volatility relative to historical levels. To be specific, thequiet ranking sorts stocks based on the six-day statistical volatility com-pared to the 100-day. According to the site, “These stocks are candidatesfor sideways trades like calendar spreads and butterflies.”

VOCABULARY LIST


Body

Butterfly

Calendar spread

Collar

Condor

Diagonal spread

Directionless

Equilibrium level

Iron butterfly

Range-bound

Resistance

Sideways

Support

Theta

Time decay

Trading range

Wasting asset

Wings


SOLUTIONS

1. In sideways markets, option strategies can be developed to takeadvantage of ______________.

Answer: B—Theta decay.

Discussion: Theta is a Greek letter used to define how an optionsprice will change due to the passage of time. It is another term fortime decay, which refers to the fact that option premiums lose valueas the expiration date draws closer.

2. A sideways market is a market that ______________.

Answer: C—Stays between consistent resistance and support levels.

Discussion: A sideways or range-bound market is the opposite of atrending market. It is a period of quiet trading that sees little pricemovement in the underlying asset. Traders often use technical support and resistance levels to identify the trading range of a sideways market.

3. Name the three parts of a butterfly strategy.

Answer: Upper wing, body, and lower wing.

Discussion: With a long butterfly, the strategist sells two at-the-money options and buys an in-the-money and an out-of-the money op-tion. In that case, the at-the-money options are considered the body.The option with the higher strike price is the upper wing and theoption with the lower strike price is the lower wing.

4. The body of a butterfly spread contains ______________.

Answer: D—An option with the strike price in between the supportand resistance levels.

Discussion: Ideally, the strategist will use technical support andresistance levels to identify the best strike prices to use for the bodyof the butterfly spread.

5. The wings of a butterfly spread are comprised of ______________.

Answer: B—Options with the strike prices at both ends of the trading range.

Discussion: Establishing the wings using strike prices near the up-per and lower ends of the trading range will help increase the odds ofsuccess when establishing long butterflies. Ideally, if the underlying



instrument revisits the upper or lower bands of the trading range, itwill revert and head back toward the strike price of the body.

6. A long butterfly spread consists of ______________.

Answer: A—Going long (buying) the wings and going short (selling)the body (the middle strike options).

Discussion: With a long butterfly, the strategist sells two at-the-money options and buys an in-the-money and an out-of-the moneyoption.

7. Money is made on a long butterfly when the market closes______________.

Answer: B—In-between the wings.

Discussion: Ideally, the underlying instrument will stay within a trad-ing range. If it moves towards the middle strike prices (of the shortoptions), the short options will expire worthless and the strategistcan keep the premium.

8. Calculate the values for the following long butterfly trade:


Short 2 December IBM 85 Calls @ 5.00


IBM is currently trading at $85.

Answer:

Net debit = [(7.50 + 3) – (2 × 5)] × 100 = $50 [(Long – short premiums)× 100].

Maximum reward = [(85 – 80) – .50] × 100 = $450 [(Difference be-tween strikes – net debit) × 100].

Maximum risk = $50 (Limited to the net debit paid).

Upside breakeven = (90 – .50) = $89.50 (Highest strike – net debit).

Downside breakeven = (80 + .50) = $80.50 (Lowest strike + net debit).

Discussion: The long butterfly is a limited risk strategy with a maxi-mum loss equal to the net debit paid. The maximum reward is equalto the difference between highest strike and the short strike minusthe net debit. Maximum profit is realized when the stock price equalsthe short strike. The upside breakeven equals the highest strike priceminus the net debit paid, and the downside breakeven equals thelowest strike price plus the net debit paid.



9. In a long condor, you need to ______________.

Answer: C—Go short the two inner option strikes of the body and golong the wings.

Discussion: Just as with the long butterfly, the long condor involvesselling two options and buying two options. However, the optionsthat are sold will have two different strike prices; so with the longcondor, the strategist is buying four separate contracts.

10. Calculate the values for the following long condor trade:





Answer:

Net debit = [(8 + 1) – (5 + 2)] × 100 = $200 [(Long – short premi-ums) × 100].

Maximum reward = [(35 – 30) – 2] × 100 = $300 [(Difference betweenstrikes – net debit) × 100].

Maximum risk = $200 (Limited to the net debit).

Upside breakeven (75 – 2) = $73 (Highest strike – net debit).

Downside breakeven (60 + 2) = $62 (Lowest strike + net debit).

Discussion: The maximum risk of the long condor is the debit paid.The best reward is equal to the difference between the strike pricesminus the net debit. The upside breakeven is equal to the higheststrike price minus the net debit. The lowest strike price is equal to thedownside breakeven plus the net debit.

11. A long iron butterfly is a combination of ______________.

Answer: C—A bear call spread and a bull put spread.

Discussion: The long iron butterfly is a strategy that consists of fouroptions with the same expiration date and different strike prices. To es-tablish the trade, the strategist will buy one higher strike call and sellone lower strike call, which is the same as a bear call spread. Thestrategist will also sell a put and buy a lower strike put, which is thesame as a bull put spread. The short puts and calls will be at- or near-the-money. The long puts and calls will be out-of-the-money. The ideais to see the underlying asset stay in a range and for the short optionsto expire with little or no value. The long options serve as a hedge inthe event of a significant move higher or lower in the underlying asset.



12. Calculate the values for the following long iron butterfly trade:

Long 1 EBAY January 75 Call @ $2.50

Short 1 EBAY January 70 Call @ $5.00

Short 1 EBAY January 65 Put @ $2.00

Long 1 EBAY January 60 Put @ $1.00

Answer:

Net credit = [(5 + 2) – (2.50 + 1)] × 100 = $350 [(Short – long premi-ums) × 100].

Maximum reward = $350 (Limited to the net credit).

Maximum risk = [(75 – 70) – 3.50] × 100 = $150 [(Difference betweenlong and short strikes – net credit) × 100].

Upside breakeven = (70 + 3.50) = $73.50 (Strike price of upper shortcall + net credit).

Downside breakeven = (65 – 3.50) = $61.50 (Strike price of lowershort put—net credit).

Discussion: The long iron butterfly is established for a credit, whichis equal to the premium received for the short options minus the pre-mium paid for the long options. The maximum reward is the netcredit. The maximum risk is equal to the difference between thestrike prices minus the credit. The upside breakeven equals the shortcall strike price plus the credit. The downside breakeven equals thestrike price of the short put minus the credit.

13. A calendar spread is a combination of ______________.

Answer: A—A long option and a short option.

Discussion: In the calendar spread, the strategist is buying a long-term option and also selling a short-term option. Both options havethe same strike prices, but different expiration dates. Calendarspreads can be created with either puts or calls.

14. A diagonal spread is a combination of ______________.

Answer: A—A long option and a short option.

Discussion: Diagonal spreads can be constructed in different ways.In any situation, however, the strategist is buying an option and alsoselling an option. The options will have different expiration dates anddifferent strike prices. For instance, a diagonal spread can be createdby purchasing a longer-term out-of-the-money call and simultane-ously selling a shorter-term at-the-money call.



15. A collar strategy is a combination of ______________.

Answer: B—A covered call and a protective put.

Discussion: A collar is created around a stock by purchasing a putoption and selling a call option. In most cases, both the call and theput will be out-of-the-money. The strategy is similar to the protectiveput, but the cost of the put is offset with the sale of a call. The collarhas limited risks and limited rewards.

MEDIA ASSIGNMENT

This chapter encourages readers to visit the Optionetics.com home pageand use the free ranker to search for stocks with low volatility. By click-ing on the “Quiet” button, readers can generate a list of stocks that haverelatively low levels of statistical volatility relative to the past. Sub-scribers using Optionetics.com Platinum will be able to provide more re-fined screens that can produce a list of low-volatility stocks. Often, thesecompanies are in industries with stable profits like consumer products,groceries, or pharmaceuticals.

It is often helpful to generate a price chart of promising stocks. Bycharting the quiet stocks, traders should be able to identify support andresistance levels, which can also help identify potential candidates for thevarious range-bound strategies discussed in this chapter. As usual, newtraders are encouraged to paper trade and back-test these strategies forrange-bound markets before actually putting money on the line.


Body: The inner part of a butterfly spread. In the case of the long butterfly,it represents the options that are being sold and that have strike pricesbetween the highest and lowest strike prices.

Butterfly: The sale (or purchase) of two identical options, together withthe purchase (or sale) of one option with an immediately higher strike andone option with an immediately lower strike. All options must be the sametype, have the same underlying, and have the same expiration date.

Calendar spread: A spread consisting of the purchase of one long-termoption and the sale of one short-term option of the same type with thesame exercise price.



Collar: A type of strategy that involves buying shares, selling calls, andbuying puts. It is a combination of a covered call and a protective put.

Condor: The sale (or purchase) of two options with consecutive exerciseprices, together with the purchase (or sale) of one option with an immedi-ately lower exercise price and one option with an immediately higher ex-ercise price.

Diagonal spread: A two-sided spread consisting of buying a long-termoption and selling a shorter-term option with different strike prices. Op-tions are of the same type and have the same underlying asset.

Directionless: Refers to an investment that lacks direction and is not trending higher or lower. Certain options strategies work well when the underlying asset is not moving higher or lower (i.e., when it isdirectionless).

Equilibrium level: The level where supply meets demand. The meanbetween an asset’s support price and resistance price.

Iron butterfly: The combination of a long (or short) straddle and a short(or long) strangle. All options must have the same underlying and have thesame expiration.

Range-bound: Refers to an investment or market that is not trendinghigher or lower, but rather remaining within a narrow price span.

Resistance: A price level that serves as a ceiling to higher prices. A stockmight turn away from this price level on a few occasions.

Sideways: An investment or market that lacks clear direction and tendsto show relatively little price change.

Support: A price level at which a stock or market begins seeing increas-ing demand or buying interest. It serves as a floor to lower prices. A majorsupport area is one that has been tested on several occasions and over asustained period of time. When a major support area is broken and thestock or market begins to falter, a more meaningful move to the downsidemay occur. For that reason, technicians consider major support areas tobe significant.

Theta: The Greek letter that refers to the loss in an option’s value due tothe passage of time. Theta is expressed as a number such as –.10 or –.05.

Time decay: The process of options losing value as the expiration dateapproaches.



Trading range: The recent high and low prices of a stock or other invest-ment that serve as resistance and support.

Wasting asset: An investment that loses value over time. Options haveset expiration dates and lose value as time passes, so they are consideredwasting assets.

Wings: A term to describe a portion of a butterfly or condor. In a long but-terfly, for instance, the wings are the options that are purchased and havethe highest and lowest strike prices. The body consists of the short optionswith the middle strike prices.



CHAPTER 11

Increasing YourProfits withAdjustments

SUMMARY

Experienced options traders are continuously assessing the risk/rewardprofile of open positions because as the underlying asset changes in value,so will other factors. For instance, the delta of a position can change dra-matically as the underlying asset moves higher or lower. So, to stay deltaneutral in a strategy like a long synthetic straddle, an options strategistmust often make modifications to the position. This may include buyingmore contracts or shares or selling them. When a strategist makes changesto a position due to price movements in the underlying asset, the strategistis making an adjustment to the position. The strategist does not need totell the broker that an adjustment is being made. Instead, the trader simplyenters the order to buy or sell more options or shares in order to bring theposition back to delta neutral.

This chapter explores the process of adjustments. For instance, howdo changes in the market influence the overall position delta of the trade?If the move is significant, it might be time to adjust the trade. Often, bymaking an adjustment, a trader can increase profits on the trade by bring-ing the trade back to delta neutral. In addition, adjustments can be madeto lock in profits or to help salvage the value of a losing trade. The mostimportant factor to understand is that option positions are not just openedand closed. In many cases, they can be modified with adjustments toimprove their overall risk/reward profiles.

141



1. Name three things you can do when the market moves and your tradeis no longer delta neutral.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

2. An adjustment can be made by ______________ to offset your posi-tion to bring it back to delta neutral.

A. Buying or selling options.

B. Buying or selling futures.

C. Buying or selling stocks.


3. Name the two sides of a delta neutral trade.

1. _________________________________________________________

2. _________________________________________________________

4. Stock has a ______________ delta.

A. Fixed.

B. Variable.

C. Fixed or variable.

5. Options have ______________ deltas.

A. Fixed.

B. Variable.

C. Fixed or variable.

6. ATM options are easy to work with because they have ______________.

A. Low liquidity and thin price spreads.

B. Low liquidity and large price spreads.

C. High liquidity and thin price spreads.

D. High liquidity and large price spreads.

7. Time-based adjustments are based on ______________.

A. The number of days left until expiration.

B. Regular intervals (days, weeks, months, etc.).



C. The movements of the sun.


8. Event-based adjustments are most likely to occur ______________.

A. When a special event dictates the adjustment.

B. At regular intervals (days, weeks, months, etc.).

C. Based on an expected event that is known beforehand.


9. What is the key advantage of using an at-the-money option?

A. It will have several strike prices.

B. It is more likely to have high open interest and liquidity.

C. The strike price will be slightly above the market value of theunderlying instrument.

D. The strike price will be slightly below the market value of theunderlying instrument.

10. Calls have ______________ deltas.

A. Negative.

B. Fixed.

C. Positive.


11. Puts have ______________ deltas.

A. Negative.

B. Fixed.

C. Positive.


MEDIA ASSIGNMENT

In this media assignment, we are going to return to the free options cal-culator at the Chicago Board Options Exchange (CBOE) and computethe deltas of various options positions. Once your PC is booted and on-line, type www.cboe.com into the web browser, which will take you tothe Chicago Board Options Exchange web site. From the CBOE homepage, click the “Trading Tools” tab, then the “Volatility Optimizer,” and

Increasing Your Profits with Adjustments 143


then click on “Options Calculator.” Next, select “American” in the stylebox. (Note: If the calculator on the CBOE site is not available, readerscan use any options calculator that includes the variable delta to com-plete this assignment.)

Next, input some variables into the calculator. First, let the stockprice equal 60 and the strike price equal 75; the volatility is 30 percent, theannual interest rate is 5 percent, and the company pays no dividend (quar-terly dividend amount equals 0). Next, in the “Days Left to Expiration”box, click “Days Until Expiration” and enter the number 100. We are goingto look at an options contract with 100 days remaining until expirationthat has a strike price of 75 and volatility of 30 percent, with an underlyingsecurity trading at $60 that pays no dividends. Now, write down the deltaof the put and the delta of the call.

Let’s assume that the stock price begins to climb higher. Change theequity price to 70. What are the deltas now? What about at 75? Now, as-sume we buy a straddle using one put and one call. What is the delta ofthis position? Or, assume that we buy 100 shares and buy two puts. Whatis the position delta? Finally, assume that the stock price climbs to 80.What are the deltas of the put and the call? What are the position deltas ofthe straddle and the long synthetic straddle? In the case of the straddle,what can we do to get back to delta neutral?

VOCABULARY LIST

SOLUTIONS

1. Name three things you can do when the market moves and your tradeis no longer delta neutral.

Answer: Exit the trade, maintain the trade as is, or make an adjustment.

Discussion: There are advantages and disadvantages to each ofthe three courses of action. So, ultimately, the best alternative will


Adjustment

Directional trade

Event-based adjustment

Fixed delta

Liquidity

Negative delta

Open interest

Positive delta

Thin spreads

Time-based adjustment

Variable delta


depend on the specific situation. Since the key to profitable tradinglies in assessing the available choices, learning the benefits of adjust-ing can help you to become a more profitable trader.

2. An adjustment can be made by ______________ to offset your posi-tion to bring it back to delta neutral.

Answer: D—All of the above (buying or selling options, futures, orstocks).

Discussion: Delta neutral trades are created by simultaneouslypurchasing (or selling) the underlying asset (stocks, futures, exchange-traded funds, etc.) along with the purchase (or sale) of optionscontracts.

3. Name the two sides of a delta neutral trade.

Answer: Hedge and directional bet.

Discussion: You can think of a delta neutral position as two trades.The first is a directional bet on a market, stock, or futures contract.The other is a hedge in case the directional bet goes awry.

4. Stock has a ______________ delta.

Answer: A—Fixed.

Discussion: Delta is the measure of the price change of a derivativerelative to the price change of an underlying asset. The delta of an op-tions contract can change as the price of the underlying asset moveshigher or lower. It varies. However, stocks (and futures contracts) al-ways have a delta equal to 100. If a stock price moves up $1, the posi-tion increases in value by $1 times the number of shares. It nevervaries; it is fixed.

5. Options have ______________ deltas.

Answer: B—Variable.

Discussion: Each options contract has a unique delta that changesover time. It can range between 0 and 100. An option with a high deltawill move very much like the price of the underlying asset. For in-stance, a contract with a delta of 100 will experience a one-to-oneprice movement with the price changes of the underlying asset.Importantly, however, the delta can change over time. It is variable.

6. ATM options are easy to work with because they have ______________.

Answer: C—High liquidity and thin price spreads.

Discussion: At-the-money options tend to attract the most amountof interest and are often more liquid than other strike prices for that



reason. The spreads, or difference between bids and offers, will often be smaller as well. This is especially true for the near-term orfront-month options.

7. Time-based adjustments are based on ______________.

Answer: B—Regular intervals (days, weeks, months, etc.).

Discussion: Strategists sometimes use regular time intervals todecide when to adjust a position. For instance, a trader might decideto adjust the position every two weeks. This is an example of a time-based adjustment.

8. Event-based adjustments are most likely to occur ______________.

Answer: A—When a special event dictates the adjustment.

Discussion: Some options traders wait for a specific event to dictatewhen an adjustment should be implemented on an open position.Earnings announcements, takeover talk, and management shake-upsare examples of events that might trigger an adjustment to an openstock option position.

9. What is the key advantage of using an at-the-money option?

Answer: B—It is more likely to have high open interest and liquidity.

Discussion: At-the-money options tend to have higher levels of openinterest when compared to other strike prices. High open interest, inturn, is a sign of liquidity and robust levels of trading activity. Theseoptions tend to be more liquid than others.

10. Calls have ___________ deltas.

Answer: C—Positive.

Discussion: As the price of the underlying asset moves higher, thecall will appreciate in value. Thus, the call option has a positive delta.Calls move in the same direction as the price of the underlying asset.

11. Puts have ___________ deltas.

Answer: A—Negative.

Discussion: As the price of the underlying asset moves higher, the put option will lose value. As the price of the underlying assetfalls, the put will increase in value. Therefore, puts have negativedeltas. They move in the opposite direction to the price of the underlying asset.



MEDIA ASSIGNMENT

In this chapter, readers are encouraged to use the options calculator at theChicago Board Options Exchange to find the deltas of a call, a put, a strad-dle, and a long synthetic straddle. Readers should notice that as the stockprice moves higher, the delta of the call increases. Meanwhile, the delta ofthe put also increases (becomes less negative). Using the numbers providedwould produce a table similar to the one shown.

Stock Price Call Delta Put Delta

60 0.10 –0.97

70 0.39 –0.63

75 0.57 –0.45

80 0.72 –0.29

The reader is also asked to compute the delta of the straddle when thestock price equals the strike price of 75. At that time, the position wouldhave a delta of +12 (57 – 45). The long synthetic straddle, which would in-clude 100 shares and two puts, would have a positive delta of 100 minus45 minus 45, or +10. Finally, the last question asks to compute the positiondeltas of the straddle and the long synthetic straddle when the stock pricereaches 80. In that case, the straddle would have a delta of 43 (72 – 29)and the long synthetic straddle would have a delta of 42 (100 – 29 – 29).So, what could the strategist do with the long synthetic straddle to movethe position closer to delta neutral? Buy one more put, which would givethe position a delta of only +13.


Adjustment: Making a change to a trade in order to bring it back to deltaneutral and alter the reward/risk ratio. Traders often make adjustments todelta neutral strategies like long straddles and long synthetic straddles.

Directional trade: A trade that requires the underlying asset to move inone direction in order to produce profits. To make a profit, the trader mustdetermine before placing a directional trade which way the asset will go.Buying stocks is an example of a directional bet because the stock pricemust move higher in order to generate profits.

Event-based adjustment: A type of adjustment to an options contractthat is based on a specific event like an earnings announcement, a profitreport, or a management change.



Fixed delta: A delta figure that does not change due to any price changes.Stocks and futures contracts have a fixed delta of plus or minus 100.

Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneysthat may be required on short notice, whether for emergencies or forplanned purchases.

Negative delta: A delta that moves opposite to the price of the underly-ing asset. For instance, a put has a negative delta because as the underly-ing asset moves higher, the value of the put moves lower.

Open interest: The total number of options contracts that have beenopened and not yet closed out.

Positive delta: A delta that moves in the same direction as the underly-ing asset. Calls, for example, have positive deltas because they appreciateas the underlying asset moves higher.

Thin spreads: Large gaps between the bids and offers caused by infre-quent and illiquid trading. Thin spreads tend to move a great deal and willoften move against the trader once an order is submitted.

Time-based adjustment: A type of modification to an options contractthat occurs at regular intervals (five days, two weeks, one month, etc.).Strategists sometimes use time-based adjustments to keep positionsdelta neutral.

Variable delta: A delta that changes as the price of the underlying assetmoves higher or lower. Options have variable deltas.



CHAPTER 12

Choosingthe RightBroker

SUMMARY

Choosing the right broker can be a difficult task, but it can also prove to beone of the most important trading decisions that you can make. Newtraders will often choose a broker based on the fees charged (i.e., thecheaper, the better). Yet, while keeping trading costs low is an importantfactor to consider, other aspects of the broker’s responsibilities and acces-sible tools—such as the quality of executions, online tools, and research—can prove equally important over the long run.

In this chapter, we hope to help you determine what defines the rightbroker for you. First, it’s important to understand how brokers operate,their roles and responsibilities, and what separates the quality brokersfrom the inferior firms. In addition, there are several different types of bro-kers. Some offer rock-bottom commissions, but nothing else. Others spe-cialize in a specific investment (stocks, bonds, mutual funds, etc.), andsome offer one-stop shopping to solve a variety of financial needs. Choos-ing from the wide array of brokers available today often requires a look atyour needs as a trader in order to determine which one is right for you.


1. Define the word broker.

____________________________________________________________

____________________________________________________________

149


2. What is the primary difference between a self-directed broker and afull-service broker?

____________________________________________________________

____________________________________________________________

3. When you buy or sell a security through a brokerage firm, you pay______________.

A. A commission.

B. Interest.

C. Nothing.


4. What is an advantage of using an online broker?

A. In most cases, you can place trades through a live broker if youneed to.

B. Commission costs are cheaper.

C. Online brokers often provide a wide range of research, invest-ment tools, and information.


5. A fill is a Wall Street term meaning ______________.

A. What traders do on their lunch break.

B. The execution (price) of a trade.

C. When too many orders are submitted at once.

D. The price charged in addition to the commission.

6. Many options traders focus on commissions, but ______________ canbe just as important.

A. Interest charges.

B. Quality of executions.

C. Location.

D. Freebies.

7. Payment for order flow ______________.

A. Always leads to the best execution.

B. Is often a conflict of interest for the brokerage firm.

C. Can lead to poor fills.



D. A and B.

E. B and C.

8. The duty of best execution ______________.

A. Requires brokerage firms to work for their clients and shop forthe best available prices.

B. Is the responsibility of the trader, not the broker.

C. Is a rule imposed by the Options Clearing Corporation.


9. If a broker encourages a client to do many trades in order to generatemore commissions, the broker is ______________.

A. Churning the account.

B. Failing to live up to the duty of best execution.

C. Involved in payment for order flow.


10. Front running is ______________.

A. A violation of current regulations.

B. The practice of trading ahead of customer’s orders.

C. The misuse of privileged information.


11. In order to open an options trading account with most brokeragefirms, new customers must ______________.

A. Demonstrate a sufficient amount of investment experience.

B. Complete the options approval form.

C. Have a certain net worth.


12. SEC stands for the ______________.

MEDIA ASSIGNMENT

In order to learn more about brokers, let’s get online and find some infor-mation. There is plenty of free information out there. One starting place isthe brokerage review section at Optionetics.com. To access the site, visit

Choosing the Right Broker 151


www.optionetics.com and look for the tab that says “Broker Review.”From there, you can compare brokers based on commission charges, on-line trading capabilities, and options usefulness. The brokerage reviewsection provides profiles for a dozen or so leading brokerage firms: thefirms’ online trading capabilities, the commissions, any research toolsavailable, and important tidbits such as telephone numbers, locations, andeach firm’s web site address.

After looking through the broker review section, visit the web sites ofsome brokerage firms that interest you. Most brokerage sites offer infor-mation about trading demos, charting capabilities, research tools, specialoffers, and other information specific to that brokerage firm. Once youopen a brokerage account, you could be with that firm for many years,even decades. So, take some time in the beginning to find the one that isright for you.

Finally, keep an eye out for information about brokerage firms in vari-ous news sources. A number of financial publications and web sites alsoconduct annual rankings of brokerage firms. Barron’s provides a regular re-view of various brokerage firms (see, for instance, the article “Trading Up,”by Theresa Carey, March 8, 2004). In the spring of 2004, the weekly publica-tion picked OptionsXpress as its top online broker. However, the rankingschange from year-to-year. To stay current, look for the latest articles and doa web search using keywords like “best brokers” or “top brokerage firms.”

VOCABULARY LIST


Broker

Broker-assisted trade

Broker/dealer

Churning

Clearinghouse

Commission

Discount broker

Duty of best execution

Execution

Fill

Front running

Full-service broker

Hedge fund

Inside information

Insider trading

Institutional investor

Listed/listing

Live broker

National Association of SecuritiesDealers (NASD)

Online broker

Options approval form


SOLUTIONS

1. Define the word broker.

Answer: A broker is an individual or entity that is licensed to buyand sell marketplace securities and/or derivatives to traders and investors.

Discussion: Broker is a term used rather loosely to describe either afirm or an individual that is authorized to trade investment securities.If your next-door neighbor tells you that he or she works as a broker,he or she probably has passed the Series 7 licensing exam, whichgives him or her the authority to take orders for stocks, bonds, andmutual funds. However, brokers must also work with firms that areregulated by the Securities and Exchange Commission and the National Association of Securities Dealers.

2. What is the primary difference between a self-directed broker and afull-service broker?

Answer: Full-service brokers offer advice in addition to executingorders. Self-directed brokerage firms are for investors or traders whomake their own decisions.

Discussion: A full-service firm can provide you with investment tools,information and advice that is not available at self-directed firms.However, these services come at a cost. In most cases, the cost is inthe form of higher commissions. Therefore, do-it-yourself investorswho are seeking lower commissions often use self-directed firms.

3. When you buy or sell a security through a brokerage firm, you pay______________.

Answer: A—A commission.

Discussion: The primary source of revenue for many brokeragefirms is the commissions from trading. Individual brokers often make


Options Clearing Corporation(OCC)

Order

Payment for order flow

Privileged information

Retail investor

Securities and ExchangeCommission (SEC)

Self-directed broker

Series 7

Ticket


a living from commissions. When a client buys an investment secu-rity, he or she is charged a commission. When the client sells thatsecurity, he or she is also charged a commission.

4. What is an advantage of using an online broker?

Answer: D—All of the above (in most cases, you can place tradesthrough a live broker if you need to; commission costs are cheaper;online brokers often provide a wide range of research, investmenttools, and information).

Discussion: Most online brokers allow you to trade online or througha live broker. Generally, there is a higher commission imposed forbroker-assisted trades. Nevertheless, commissions at online firms aregenerally cheaper than with full-service brokers. In addition, in orderto compete with one another, many online brokerage firms provide awide range of research, investment tools, and information.

5. A fill is a Wall Street term meaning ______________.

Answer: B—The execution (price) of a trade.

Discussion: On Wall Street, the term fill refers to the execution of atrade. For instance, “That was a good fill on my order for IBM calls”or “I was filled on my IBM order at $50 a share.”

6. Many options traders focus on commissions, but ______________ canbe just as important.

Answer: B—Quality of executions.

Discussion: Poor executions can often cost a trader more moneythan higher commissions. Ideally, a trader looks for a broker who willoffer both great executions and rock-bottom commissions. In the realworld, however, there is often a trade-off between the two.

7. Payment for order flow ______________.

Answer: E—B and C (is often a conflict of interest for the brokeragefirm and can lead to poor fills).

Discussion: Payment for order flow describes the practice of send-ing orders to specific exchanges and receiving a cash payment forthese orders. Brokerage firms that engage in this practice often face aconflict of interest because, since they receive a payment for routingan order to a specific exchange, they might not be sending the orderto the exchange that is showing the best prices. For that reason,clients sometimes don’t get the best executions when brokeragefirms receive payments for orders.



8. The duty of best execution ______________.

Answer: A—Requires brokerage firms to work for their clients andshop for the best available prices.

Discussion: Brokerage firms have a duty of best execution, whichrequires them to try to get the best prices on all customer orders. Inthe options market, where options are listed on multiple exchanges,this often involves sending the order to the exchange showing thebest prices.

9. If a broker encourages a client to do many trades in order to generatemore commissions, the broker is ______________.

Answer: A—Churning the account.

Discussion: When a broker encourages a client to make frequent andsometimes unwarranted transactions within the client’s account, thebroker may be guilty of churning the account. This practice is prohib-ited and, if found guilty, the broker could face disciplinary action.

10. Front running is ______________.

Answer: D—All of the above (a violation of current regulations, thepractice of trading ahead of customers’ orders, the misuse of privi-leged information).

Discussion: Front running, the practice of trading ahead of a cus-tomer’s orders, is generally not an important issue with small orders.However, front running ahead of large orders can be significant. Forinstance, if a trader at a brokerage firm knows that a large institu-tional client is going to buy a million shares of XYZ, that trader mightbuy XYZ ahead of the order because the stock price will probably goup once the order is executed. However, this type of front running isa violation of current regulations and also represents the misuse ofprivileged information.

11. In order to open an options trading account with most brokeragefirms, new customers must ______________.

Answer: D—All of the above (demonstrate a sufficient amount ofinvestment experience, complete the options approval form, andhave a certain net worth).

Discussion: In order to begin trading options, a new customermust open an account and submit an options approval form.Among other things, brokerage firms look at clients’ experiencelevel and net worth before allowing them to trade options or certainhigh-risk strategies.



12. SEC stands for the ______________.

Answer: Securities and Exchange Commission.

Discussion: The Securities and Exchange Commission was createdby Congress to regulate the securities markets and protect investors.It consists of five commissioners appointed by the President of theUnited States and approved by the Senate. Most traders simply referto the commission as the SEC.

MEDIA ASSIGNMENT

After completing the media assignment in this chapter, readers shouldhave a large amount of information regarding online brokers. The BrokerReview section at www.optionetics.com provides information on the toponline brokerage firms. In addition, after visiting various web sites of theindividual brokers, readers should look for the annual rankings of broker-age firms in Barron’s as well as other financial publications. From there,readers should be able to identify the two or three firms that best meettheir needs, open options trading accounts, and begin trading.


Broker: A person or firm that buys and sells securities for cus-tomers. Most brokers charge commissions for executing transactionsfor customers.

Broker-assisted trade: A trade that is handled by a live broker. Many on-line brokerage firms allow customers not only to trade over the Internet,but also to talk to a live broker for assistance.

Broker/dealer: Another term used for brokerage firms or brokers.

Churning: Excessive trading in a customer’s account by a broker who seeksto increase commissions. The practice is a violation of NASD regulations.

Clearinghouse: An institution established separately from the stockexchanges that ensures that the payment and delivery of stocks or optionsis handled accurately and efficiently.

Commission: A charge for executing a trade. Most brokerage firmscharge commissions on stock and options transactions.

Discount broker: A brokerage firm that offers lower commission ratesthan a full-service broker, but does not offer services such as advice,research, and portfolio planning.



Duty of best execution: Brokerage firms have the obligation to look forthe best prices for their customers. This often involves executing tradespromptly or sending the order to the exchange that is currently showingthe best quotes.

Execution: The process of completing an order to buy or sell a security.Once a trade is executed, it is reported in a confirmation report.

Fill: The execution of an order; also, the price at which an order is executed.

Front running: Broker practice of placing an order ahead of a customer’sorder. This practice can represent a conflict of interest and is prohibited.

Full-service broker: A type of stockbroker who provides more thanstock quotes and order execution, including (and not limited to) portfolioplanning and management, investment ideas, and researching specific in-vestments. Since these brokers provide more than order taking and stockquotes, their commissions are higher.

Hedge fund: A private investment partnership that can use leverage and de-rivatives, take both long and short positions, and invest in many markets.Hedge funds can succeed in any market environment, even one with sharplydeclining prices, because they can take advantage of many speculativestrategies, including program trading, swaps, arbitrage, and selling short.

Inside information: Relevant information about a company that has notyet been made public. It is illegal for holders of this information to maketrades based on it, however received.

Insider trading: Making investment decisions based on information thatis not yet public. Although trading based on this type of inside informationdoes occur, it is against regulations.

Institutional investor: A customer at a brokerage firm or an investorthat makes investment decisions for a large financial institution or hedgefund. Examples include portfolio managers, some professional financialadvisers, mutual fund managers, and hedge fund traders.

Listed/Listing: Refers to the exchange where an investment trades. Aninvestment is “listed” if it is traded on an exchange. For instance, compa-nies pay fees to be traded on an exchange and must abide by the rules andregulations set out by the exchange to maintain listing privileges.

Live broker: A human being who answers calls and takes orders.

National Association of Securities Dealers (NASD): The Americanself-regulatory organization of the securities industry responsible for theregulation of Nasdaq and the over-the-counter markets.

Online broker: A brokerage firm that allows clients to trade over theInternet using Web-based trading platforms.



Options approval form: A document that must be completed bytraders before trading options is allowed by a brokerage firm. Brokeragefirms use the form in order to determine if options trading is suitable forthe investor.

Options Clearing Corporation (OCC): The clearing entity for all U.S.options exchanges. The OCC is the guarantor and is responsible for ensur-ing that contracts are fulfilled.

Order: A customer request to buy or sell an investment security.

Payment for order flow: The practice of routing orders to specific ex-changes in return for payments. Various brokerage firms engage in thiscontroversial practice.

Privileged information: Information that is not available to the public.See also Inside information and Insider trading.

Retail investor: Individual investor making decisions for a personal port-folio. In contrast to institutional investors who make decisions on behalf offinancial institutions, retail investors represent individual trading accounts.

Securities and Exchange Commission (SEC): A commission createdby Congress to regulate the securities markets and protect investors. It iscomposed of five commissioners appointed by the President of the UnitedStates and approved by the Senate. The SEC enforces, among other acts,the Securities Act of 1933, the Securities Exchange Act of 1934, the TrustIndenture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.

Self-directed broker: A firm that caters to brokerage customers whomake their own decisions and seek lower commissions.

Series 7: An examination for a license that allows individual stockbro-kers to serve brokerage customers.

Ticket: The details of a trade—number of shares, type of order, prices—that must be submitted for a trade to be executed. In the past, this infor-mation was handwritten on a piece of paper called a ticket.



CHAPTER 13

ProcessingYourTrade

SUMMARY

Trades are executed on exchanges. This chapter explores the processthat a trade goes through from beginning to end. Stocks, futures, and op-tions trades are investigated in depth so that the reader can understandthe extraordinary process a trade goes through to be executed. Addition-ally, it is essential to master the art of placing orders. This chapter also in-vestigates the order process itself, including guiding the reader throughthis precise process.

There are many variables and terms that are used in the trading field.In addition, each broker has his or her own way of doing things. Nonethe-less, by learning the basic concepts and being clear when placing an order,even a new trader can place a complicated trade correctly. Though mosttraders stick to using market and limit orders, it’s a good idea to get a basicunderstanding of the various order-placing terms so that you are aware ofwhat is available for you as a trader.


1. What are the three primary U.S. stock exchanges?

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

159


2. U.S. exchanges are regulated by the ______________.

A. U.S. Congress.

B. National Stock Exchange Commission.

C. Securities and Exchange Commission.

D. Securities Exchange Act.

3. The ______________ regulates the nation’s commodity futures exchanges.

A. Commodity Futures Trading Commission.

B. Securities and Exchange Commission.

C. National Commodity Exchange Commission.

D. U.S. Congress.

4. Describe the process your order goes through to get filled at a stockexchange.

____________________________________________________________

____________________________________________________________

5. A ______________ is there to create liquidity and narrow the spread.

A. Specialist.

B. Floor broker.

C. Market maker.

D. Exchange officer.

6. Orders are filled by a system of ______________ at a commoditiesexchange.

A. Electronic review.

B. Specialists making transaction matches.

C. Market makers creating a market.

D. Open outcry.

7. Floor traders make most of their money on ______________.

A. The bid-ask spread.

B. Commissions.

C. Leasing their seats.




8. The ______________ is the highest-volume stock options exchange.

A. New York Stock Exchange (NYSE).

B. Chicago Board Options Exchange (CBOE).

C. American Stock Exchange (AMEX).

D. Pacific Exchange (San Francisco).

9. A/an ______________ is an individual who is licensed to buy and sellmarketplace securities and/or derivatives directly to traders andinvestors.

A. Market maker.

B. Speculator.

C. Arbitrageur.

D. Broker.

10. True or False: Someone who is licensed to take an order must havethe knowledge to invest your money wisely.

11. Your broker—as your intermediary—will get paid a/an ______________for each transaction.

A. Round turn.

B. Arbitrage.

C. Commission.

D. Dividend.

12. True or False: Never make an investment while on the phone with asales call. End the call, and then think about what was told to you anddo your own analysis of risk and reward.

13. A/an ______________ is the price that you are given on an executedtrade.

A. Buy.

B. Bid.

C. Ask.

D. Fill.

14. Make a list of important items that need to be specified when placingan order.

1. _________________________________________________________

2. _________________________________________________________

Processing Your Trade 161


3. _________________________________________________________

4. _________________________________________________________

5. _________________________________________________________

6. _________________________________________________________

7. _________________________________________________________

15. If you place a ______________, you will get an immediate fill at thecurrent price.

A. Limit order.

B. Market order.

C. Day order.

D. Stop order.

16. If you place a ______________, you will have to wait until the priceyou want gets hit before the broker can execute your trade.

A. Limit order.

B. Market order.

C. Day order.

D. Stop order.

17. You want to place the following market order: Short 100 Shares ofIBM @ $87 and Long 2 September IBM 90 ATM Calls. What would youtell your broker?

____________________________________________________________

____________________________________________________________

18. The more volatile the market is, the ______________ the bid-askspread will be.

A. Narrower.

B. Wider.

C. More consistent.

D. More fluctuating.

19. Floor prices primarily depend on ______________.

A. Your broker’s execution and the exchange.

B. The bid-ask spread and volatility.

C. The bid-ask spread and liquidity.

D. Liquidity and volatility.



MEDIA ASSIGNMENT

In this chapter’s media assignment, readers are encouraged to learn moreabout how options trades are processed by visiting the web sites of thekey U.S. options exchanges. Today, there are six options exchanges in theUnited States. The two largest, the Chicago Board Options Exchange(CBOE) and the International Securities Exchange (ISE), handle the lion’sshare of the volume. However, all six exchanges have web sites availableto investors. The web sites and addresses are as follows:

Chicago Board Options Exchange www.cboe.com

The International Securities Exchange www.iseoptions.com

The Boston Options Exchange www.bostonoptions.com

The Philadelphia Stock Exchange www.phlx.com

The American Stock Exchange www.amex.com

The Pacific Stock Exchange www.pacificex.com

Take a few minutes at each web site and look around. On the first stop atthe Chicago Board Options Exchange web site, pay special attention tothe “About CBOE” area of the site. Within this section, readers will find ahistory of the Chicago Board Options Exchange. Looking through thethirty-year history of the first organized options exchange gives great in-sight about the development and evolution of options trading in theUnited States.

On your next stop, the International Securities Exchange web site in-cludes detailed descriptions of the technology that drives this relativelynew options exchange. It also explains its current structure and member-ship information. Similarly, the Boston Options Exchange, which is thenewest exchange, provides detailed descriptions about how this moderntrading mechanism works day-in and day-out.

The remaining three options exchanges also have web sites. These ex-changes trade both stocks and options. Therefore, readers can find informa-tion about the stocks and options traded on their web sites. For example,the “At the AMEX” section of the American Stock Exchange’s web site in-cludes information about the structure of the exchange as well as the tradeexecution process. Taken together, readers can find a wealth of informationabout how the options market works at the six web sites of the U.S. optionsexchanges, which will also help develop a good understanding about theoptions trading process.



VOCABULARY LIST

SOLUTIONS

1. What are the three primary U.S. stock exchanges?

Answer: New York Stock Exchange (NYSE), American Stock Exchange (AMEX), Nasdaq.

Discussion: These are the main exchanges and the ones that wehear about the most on television and read about in the newspaper.However, there are many other exchanges that play a role in provid-ing liquidity and opportunity for stock, options, and futures traders.

2. U.S. exchanges are regulated by the ______________.

Answer: C—Securities and Exchange Commission.

Discussion: The SEC has a major role in policing and setting up theappropriate rules and regulations for the marketplace. There havebeen several acts passed by Congress that the SEC has to enforce.There have been many high-profile cases the past five years that theSEC has had to oversee.

3. The ____________ regulates the nation’s commodity futures exchanges.

Answer: A—Commodity Futures Trading Commission.

Discussion: Similar to the SEC, the CFTC regulates activity in thecommodity exchanges. This commission was set up by the Com-modity Futures Trading Commission Act of 1974 and is made up offive commissioners appointed by the U.S. President and approvedby the Senate.

4. Describe the process your order goes through to get filled at a stockexchange.

Answer: You call your broker, who passes your order along via Des-ignated Order Turnaround (DOT) or by wire to a floor broker. DOT isan electronic system on the New York Stock Exchange that is used tosend small orders directly to the specialists’ posts on the tradingfloor. DOT bypasses floor brokers and speeds up the execution of


Exchange

Limit order

Market maker

Market order

Options Clearing Corporation(OCC)

Options Industry Council (OIC)

Specialist


small orders. If your order is sent by wire to a floor broker, he or shewill immediately try to fill your order or take it directly to a specialist.If the specialist matches your order, you will receive a call from yourbroker with confirmation that your order has been executed.

Discussion: The amazing thing about the order process is the speedwith which it happens. If a market order is placed, it takes just a fewseconds to get confirmation of the fill. Technology has made theprocess extremely fast and efficient.

5. A ______________ is there to create liquidity and narrow the spread.

Answer: C—Market maker.

Discussion: A market maker plays an important role in the orderplacing process. Market makers take the opposite side of a trade whenthere isn’t anyone else to take it. This means that traders can get filledon a stock at any time if they are willing to pay the going price.

6. Orders are filled by a system of ______________ at a commoditiesexchange.

Answer: D—Open outcry.

Discussion: We all have seen movies where floor traders are scream-ing and yelling and making hand signals. While this might seem veryunorganized, the open outcry method has worked for decades andcontinues to be the system used at the commodities exchanges.

7. Floor traders make most of their money on ______________.

Answer: A—The bid-ask spread.

Discussion: New traders often ask why they can’t buy at the bid andsell at the ask. This is because the floor traders need to make some-thing for the services they offer. Just like a retail store, they are notgoing to sell something unless they can make a profit.

8. The ______________ is the highest-volume stock options exchange.

Answer: B—Chicago Board Options Exchange (CBOE).

Discussion: The CBOE was the first options exchange to be estab-lished (1973). Since that time, options volume has grown at an incred-ible rate. Although other options exchanges have been created, theCBOE remains the most popular.

9. A/an ______________ is an individual who is licensed to buy andsell marketplace securities and/or derivatives directly to tradersand investors.

Answer: D—Broker.



Discussion: A broker is the liaison between a trader and the ex-changes. With the advent of online trading, hundreds of new compa-nies have been established that offer brokerage services. The hugeincrease in the number of choices often makes it difficult to narrowdown the universe of brokers to the few that you want to use.

10. True or False: Someone who is licensed to take an order must havethe knowledge to invest your money wisely.

Answer: False.

Discussion: In any profession, just because you have a license to per-form certain functions doesn’t mean you are knowledgeable enoughto make wise choices. This is why it is important to ask the appropri-ate questions when interviewing a new broker. The Optionetics sitehas an entire section dedicated to helping traders choose a broker, souse this to your advantage.

11. Your broker—as your intermediary—will get paid a/an ______________for each transaction.

Answer: C—Commission.

Discussion: Commissions have come down substantially with the ad-vent of the Internet. Even so, there still are various types of brokers,and their commissions vary widely depending on what services theyoffer. Online brokers charge small commissions if they do nothingother than route the trade. Full-service brokers charge considerablymore per transaction because of the various services they offer.

12. True or False: Never make an investment while on the phone with asales call. End the call, and then think about what was told to you anddo your own analysis of risk and reward.

Answer: True.

Discussion: Individuals get sales calls all the time with the caller try-ing to sell various investments. However, it is important to do the ap-propriate research before investing in any stock or commodity. Don’tbe lured in by promises of riches and wealth. Though some of theseinvestments might be worth a look, take the time to study the invest-ment vehicle before committing your hard-earned cash.

13. A/an ____________ is the price that you are given on an executed trade.

Answer: D—Fill.

Discussion: After a trade has been entered, your broker will give you afill price. The fill price could be the price at which a security was boughtor sold. This initial price is the basis for figuring your profits and losses.



14. Make a list of important items that need to be specified when placingan order.

Answer:

1. What kind of order you wish to place.

2. The exchange—where the order is to be placed (for futures andoptions).

3. Quantity—number of contracts.

4. Buy/sell—puts or calls (also include the strike price and expiration).

5. Contract—name of the contract.

6. Month—delivery month of the contract.

7. Price—instructions regarding price execution.

Discussion: Though a trader doesn’t need to follow this exact for-mat, it is a good idea to develop a system that works well for you andyour broker. Generally, all of these components will need to be partof the order when placed on the phone. Even when using the Inter-net, it is a good idea to have this information written down to makesure no errors are made.

15. If you place a ______________, you will get an immediate fill at thecurrent price.

Answer: B—Market order.

Discussion: Market orders are the best-known type of order and areused frequently when trading stock. However, an options tradershould use limit orders to avoid getting filled at a price much differentthan expected. Market orders should be used only when a traderneeds an immediate fill and is trading a highly liquid security.

16. If you place a ______________, you will have to wait until the priceyou want gets hit before the broker can execute your trade.

Answer: A—Limit order.

Discussion: Limit orders might take a longer time to fill, but theyprotect traders from getting a price they didn’t want. Limit orderswork well when trading options because liquidity on some optionsmight not be high enough to use market orders.

17. You want to place the following market order: Short 100 Shares ofIBM @ $87 and Long 2 September IBM 90 ATM Calls. What would youtell your broker?

Answer: “I want to buy two September/Labor Day IBM at-the-moneycalls and sell 100 shares of IBM at the market.”



Discussion: The term Labor Day is used to clarify that the month isSeptember and not December. This isn’t necessary, but it helps en-sure that the broker understands the complete trade. The clearer youare, the better the chance that the trade will be filled correctly.

18. The more volatile the market is, the ______________ the bid-askspread will be.

Answer: B—Wider.

Discussion: High volatility creates high risk for floor traders. Hence,the higher the risk to the floor trader, the higher the bid-ask spreadwill be. This is most notable when trading options because volume ismuch lighter for options than for most stocks.

19. Floor prices primarily depend on ______________.

Answer: D—Liquidity and volatility.

Discussion: Supply and demand play a major role in the prices forstocks and options. When there isn’t much demand for a stock or op-tion, the bid-ask spread will normally be wider. When volatility is highfor a security, the bid-ask spread will be wider as well. This is why itis important to trade securities with liquidity.

MEDIA ASSIGNMENT

Today, six U.S. options exchanges compete for your trades. Some, like theChicago Board Options Exchange and the American Stock Exchange,have been around for quite some time. Others, such as the Boston OptionsExchange and the International Securities Exchange, are relatively newplayers on the scene. The two largest, which handle the majority of op-tions volume today, are the Chicago Board Options Exchange and the In-ternational Securities Exchange.

All six options exchanges have excellent web sites. In this chapter,readers are encouraged to visit each one and pay special attention to thehistory of each exchange as well as the areas of the site that explain howeach is designed or structured. Doing so provides better insight into theworkings and flavor of each exchange, which will also help you to betterunderstand how options trades are processed.


Exchange: Place where a stock or an option, a future, or other deriva-tive is bought and sold. The best-known exchange is the New YorkStock Exchange.



Limit order: An order to buy a stock at or below a specified price or tosell a stock at or above a specified price. For instance, you could tell abroker, “Buy me 100 shares of XYZ Corporation at $8 or less” or “Sell 100shares of XYZ at $10 or better.”

Market maker: A dealer willing to accept the risk of holding a particularsecurity in his or her own account to facilitate trading in that security. Onthe over-the-counter markets, there are individuals and companies thatmaintain bids and offers for stocks. They must be prepared to buy or sellstocks from investors at any time.

Market order: An order to buy or sell securities at the price given at thetime the order reaches the market. This can be different from the price onthe broker’s screen, depending on how fast the market is moving. A mar-ket order is to be executed immediately at the best available price, and isthe only order that guarantees execution.

Options Clearing Corporation (OCC): Established in 1973, the organi-zation processes and guarantees the standardized options contracts thattrade on the U.S. options exchanges. It is the world’s largest equity deriva-tives clearing organization.

Options Industry Council (OIC): A nonprofit association created to in-form and educate investors about the benefits of listed options contracts.Formed in 1992, the OIC is sponsored by the major options exchanges andthe Options Clearing Corporation (OCC).

Specialist: A stock exchange member who stands ready to quote andtrade certain securities either for his or her own account or for customeraccounts. The specialist’s role is to maintain a fair and orderly market inthe stocks for which he or she is responsible. A trader on the market flooris assigned to fill bids/orders in a specific stock out of his or her own ac-count when the order has no competing bid/order to ensure a fair and or-derly market.



CHAPTER 14

MarginandRisk

SUMMARY

Every investment or trade has a potential risk and a possible reward.Theoretically, the greater an investment’s risk, the greater the potentialreward. However, in the options market, it is possible to create tradesthat have relatively high rewards, but limited risk. In addition, somestrategies have unlimited risks, but only modest rewards. By the conclu-sion of this book, the reader should understand this relationship andshould be able to utilize strategies that minimize risk while maximizingpotential rewards.

In this chapter, the basic concepts of risk and margin are explored. Aswe have duly noted, risk is inherent in every trade. There are ways to min-imize it, but risk is always a factor to consider. For example, what is therisk of holding cash? Is there a risk? Yes, the risk of holding paper cur-rency is that inflation will erode its purchasing power. So, regardless of theinvestment or strategy, risk is one of the most important characteristics ofeach investment’s viability.

Meanwhile, margin, which is the amount of cash required to be on deposit with a trader’s clearing firm in order to execute a trade, canalso alter the reward/risk ratio. In this chapter, the reader will learnwhat margin is and how it works, as well as its key advantages and disadvantages.

170



1. What are the two key elements that characterize attractive trades?

1. _________________________________________________________

2. _________________________________________________________

2. What are the two most important factors in determining the cost ofan investment?

1. _________________________________________________________

2. _________________________________________________________

3. A/an ______________ requires you to put up 100 percent of the moneyto execute the trade.

A. Margin trade.

B. Cash trade.

C. Open trade.


4. A/an ______________ allows you to put up a percentage of the calcu-lated amount in cash and the rest is “on account.”

A. Margin trade.

B. Cash trade.

C. Open trade.


5. ______________ is defined as the amount of cash required to be on deposit with your clearing firm to secure the integrity of thetrade.

A. Deposit.

B. Commission.

C. Adjustment.

D. Margin.

Margin and Risk 171


6. A/an ______________ allows traders and investors to leverage theirassets to produce a higher return.

A. Cash account.

B. Margin account.

C. Absorption account.

D. Adjunct account.

7. Margin accounts allow traders to extract up to ______________ of thecash value of their securities.

A. 25 percent.

B. 50 percent.

C. 75 percent.

D. 100 percent.

8. Using a margin account, if you buy 500 shares of XYZ at $100, howmuch will this trade cost you, not including commissions?

A. $10,000.

B. $20,000.

C. $25,000.

D. $50,000.

9. A ______________ from your broker requires you to place additionalfunds in your account. If you do not place these additional funds inyour account, your position will be liquidated.

A. Margin ratio.

B. Margin account.

C. Margin requirement.

D. Margin call.

10. True or False: If you are trading delta neutral using futures and op-tions, your margin will be close to zero, which means you will neverget a margin call.

11. If the ______________ of your trade increases, then the margin willalso increase.

A. Implied risk.

B. Risk premium.



C. Risk arbitrage.

D. Perceived risk.

12. If you do not have additional funds to place in your account to covera margin call, your position will be ______________.

A. Placed on hold.

B. Liquidated.

C. Traded by the brokerage firm.


13. Based on the rules of the Securities and Exchange Commission andthe clearing firms, margin for stocks equals ______________ of theamount of the trade.

A. 25 percent.

B. 35 percent.

C. 50 percent.

D. 75 percent.

14. For stock options, each point equals ______________.

A. $10.

B. $100.

C. $500.

D. An amount that depends on the stock.

15. Selling ______________ options, or placing an unprotected trade, hasthe highest risk and the highest margin requirements.

A. Naked.

B. Call.

C. Put.

D. Covered.

16. Combining the buying and selling of options, stocks, and/or futures creates a more complex calculation; however, this will______________ your margin requirements.

A. Increase.

B. Decrease.

C. Not affect.


Margin and Risk 173


17. ______________ is the ability to use less capital for a larger potentialreturn but can result in increased risk.

A. Volatility.

B. Liquidity.

C. Flexibility.

D. Leverage.

MEDIA ASSIGNMENT

The next media assignment takes a closer look at margin and margin ac-counts. When investors use margin, they deposit a percentage (normally50 percent) of the cost of the investment security and borrow the rest. Thebrokerage charges the investor interest on the money borrowed. The ad-vantage to buying stocks on margin, however, is that it enables the traderto control a greater amount of an investment with less capital. Therefore,margin equals leverage.

To learn more about margin accounts and current trends related tomargin, let’s visit the web site of the National Association of SecuritiesDealers (NASD). The home page is www.nasd.com. From there, click the“Investor Information” tab. Then choose “Markets & Trading” at the top ofthe page. Finally, click “Margin Information.”

Once inside the Margin Information section of the National Associa-tion of Securities Dealers web site, readers will find a wealth of informa-tion related to this topic. A section called Understanding Margin Accountswalks the reader through real world examples and situations dealing withcustomer margin accounts. The Purchasing on Margin section discusses thepotential risks of using margin. Current and historic levels of margin debtcan be found in the Margin Statistics area of the site. The information at theNASD site offers traders the opportunity to gain a comprehensive under-standing of margin including its potential benefits and pitfalls.

VOCABULARY LIST


Cash account

Cash trade

Federal Reserve

Leverage

Liquidation

Margin

Margin account

Margin call

Margin debt

Margin requirement

Margin trade

Marginable security

Naked writing

Risk


SOLUTIONS

1. What are the two key elements that characterize attractive trades?

Answer: Limited risk and unlimited reward.

Discussion: Worthwhile options trades put a limit on possible losses,but also offer the potential for large rewards. Trades that possess theopposite characteristics (i.e., unlimited risks and limited rewards)are generally discouraged.

2. What are the two most important factors in determining the cost ofan investment?

Answer: The size of the transaction (number of shares, futures, oroptions) and the risk calculated on the trade.

Discussion: The cost of a trade has two components. First, what isthe cash outlay in terms of the number of shares/contracts times themarket prices? Second, what is the possible loss or risk of the trade?Sometimes these two costs can differ significantly.

3. A/an ______________ requires you to put up 100 percent of the moneyto execute the trade.

Answer: B—Cash trade.

Discussion: In a cash trade, the investor is required to pay 100 per-cent of the cost of the trade. Since options cannot be purchased onmargin, buying puts and calls is an example of a cash trade.

4. A/an ______________ allows you to put up a percentage of the calcu-lated amount in cash and the rest is “on account.”

Answer: A—Margin trade.

Discussion: In a margin account, traders can buy stocks for less thanthe 100 percent required to cover the cost of the trade. For instance,stock traders using margin accounts can buy stocks for 50 percent ofthe actual cost of the trade. Margin requirements can change overtime, however.

5. ______________ is defined as the amount of cash required to be ondeposit with your clearing firm to secure the integrity of the trade.

Answer: D—Margin.

Discussion: Margin is the amount of money you are required to postto secure a position and the amount a company will lend you againstthe security of the investment you seek to buy.

Margin and Risk 175


6. A/an ______________ allows traders and investors to leverage theirassets to produce a higher return.

Answer: B—Margin account.

Discussion: To buy and sell securities using margin, the client mustfirst open a margin account with a brokerage firm.

7. Margin accounts allow traders to extract up to ______________ of thecash value of their securities.

Answer: B—50 percent.

Discussion: Currently, the margin requirements are 50 percent.However, margin requirements can change over time, so investorsshould check with their brokerage firms periodically before initiat-ing margin trades.

8. Using a margin account, if you buy 500 shares of XYZ at $100, howmuch will this trade cost you, not including commissions?

Answer: C—$25,000.

Discussion: Buying 500 shares of XYZ at $100 a share would cost $50,000. Since the margin requirement is 50 percent, or half,the trader pays $25,000 for 500 shares if the stock is purchased on margin.

9. A ______________ from your broker requires you to place additionalfunds in your account. If you do not place these additional funds inyour account, your positions will be liquidated.

Answer: D—Margin call.

Discussion: A margin call occurs if the equity value in a margin ac-count drops below a certain level. The deposit into the account mustoccur within one business day. If not, securities in the account willprobably be sold to cover the margin call.

10. True or False: If you are trading delta neutral using futures and op-tions, your margin will be close to zero, which means you will neverget a margin call.

Answer: False.

Discussion: If your futures side starts losing money, you may get amargin call.



11. If the ______________ of your trade increases, then the margin willalso increase.

Answer: D—Perceived risk.

Discussion: Higher risk strategies, like naked call selling, havehigher margin requirements. The exact dollar amount will vary fromone brokerage firm to the next.

12. If you do not have additional funds to place in your account to covera margin call, your position will be ______________.

Answer: B—Liquidated.

Discussion: In order to cover a margin call, an investor must eitheradd more cash to the account or liquidate some of the holdingswithin the account. The amount that is liquidated will depend on theamount needed to cover the margin call.

13. Based on the rules of the Securities and Exchange Commission andthe clearing firms, margin for stocks equals ______________ of theamount of the trade.

Answer: C—50 percent.

Discussion: Current margin requirements are 50 percent, but areoccasionally subject to change.

14. For stock options, each point of the premium equals ______________.

Answer: B—$100.

Discussion: The multiplier for stock options is 100. So an optionscontract trading for a premium of 1 is worth $100 a contract.

15. Selling ______________ options, or placing an unprotected trade, hasthe highest risk and the highest margin requirements.

Answer: A—Naked.

Discussion: Naked options writing carries extremely high risk. As aresult, brokerage firms impose high margin requirements for this typeof trading activity.

Margin and Risk 177


16. Combining the buying and selling of options, stocks, and/or fu-tures creates a more complex calculation; however, this will______________ your margin requirements.

Answer: B—Decrease.

Discussion: In general, more complex strategies that involve buyingand selling options as well as the underlying instrument can reducethe overall risk of the trade. Consequently, the margin requirementsshould be less. However, the margin requirements for complex tradeswill often vary among brokerage firms.

17. ______________ is the ability to use less capital for a larger potentialreturn but can result in increased risk.

Answer: D—Leverage.

Discussion: In the financial markets, leverage is using small amountsof money to control a much larger position. Stock options are an ex-ample of leverage because by paying a small premium investors cancontrol a large number of shares.

MEDIA ASSIGNMENT

Margin is a double-edged sword. While it can be used as leverage to gener-ate higher returns, the effect of added leverage can also lead to greaterlosses. Hence, the decision to use margin is ultimately left to the whim ofthe individual trader. Basically, margin results in a higher risk-reward situ-ation. The decision to use margin is an important one and therefore de-serves careful consideration.

In order to better understand the possible benefits and potential pit-falls of using margin, readers are encouraged to visit the “Margin Infor-mation” section of the NASD web site. It probably offers the mostcomprehensive look at margin available anywhere. Real world exam-ples and situations help to understand exactly how margin accountswork. In addition, readers will find the latest margin statistics, informa-tion on purchasing on margin, as well as potential risks associated withmargin trading.

As you can see, leverage will have a significant effect on the risk-reward outlook when 50 percent margin is used to buy shares. For instance, a 25 percent decline in the stock price results in a 50 percentloss in the margin account. However, a 10 percent gain in the stock



translates into a 20 percent gain using 50 percent margin. So, the risksare greater and the rewards potential is also higher when investors usemargin to buy stocks.


Cash account: A type of brokerage account that requires investors to payfor trades in their entirety, which is in contrast to a margin account thatallows customers to use collateral to buy securities.

Cash trade: A trade that must be paid for in its entirety once it is initiated.

Federal Reserve: The U.S. central bank that is responsible for monetarypolicy. The Federal Reserve will change interest rates and the money sup-ply in an effort to keep the economy expanding at a reasonable pace.

Leverage: Using a small amount of capital to control a much largeramount of capital. Options are an example of a trading instrument thatoffers a high leverage trading approach.

Liquidation: When the assets within a portfolio are sold or cashed out.

Margin: A deposit made by a trader with a clearinghouse to ensure thathe/she will fulfill any financial obligations resulting from his or her trades.Margin is the amount of money a company will lend you against the secu-rity of the investment you buy.

Margin account: An account in which stocks can be purchased for acombination of cash and a loan. The loan in the margin account is collat-eralized by the stock, and if the value of the stock drops sufficiently, theowner will be asked to either put in more cash or sell a portion of thestock.

Margin call: The brokerage’s demand that a customer deposit a specifiedamount of money or securities when a purchase is made in a margin ac-count; the amount is expressed as a percentage of the market value of thesecurities at the time of purchase. The deposit must be made within onepayment period.

Margin debt: The total amount of money that has been borrowed frombrokers to pay for margin trades.

Margin requirement: The amount of cash an uncovered (naked) optionwriter is required to deposit and maintain to cover the daily position valu-ation and reasonably foreseeable intraday price changes.

Margin and Risk 179


Margin trade: A trade that is executed in a margin account using lessthan 100 percent cash to pay for the transaction.

Marginable security: An investment that can be used as collateral in amargin account. A brokerage firm can tell you whether your investmentis marginable. Most exchange-traded stocks are, but options contractsare not.

Naked writing: Selling options with no hedge or offsetting position.

Risk: The potential loss associated with a trade or investment.



CHAPTER 15

A Short Coursein Economic

Analyses

SUMMARY

Economists don’t often make good traders, but having a basic under-standing of economic trends can help make sense of the day-to-day hap-penings in the futures, bond, and stock markets. For instance, aneconomic report can cause bond prices to tumble, interest rates toshoot higher, and stock index futures to fall. When the moves are sud-den and short-term in nature, they can cause volatility in the stock mar-ket to spike higher. However, long periods of stable or falling interestrates can keep volatility at bay and create a favorable environment forhigher stock prices.

This chapter explores the relationships between interest rates, bondprices, and stocks. An important factor to keep in mind is that when inter-est rates move higher, bond prices tumble. And when rates fall, bondsrally. In addition, sudden jumps in interest rates can cause money to shiftout of stocks and into interest-bearing investments—which can also makeprices fall in the stock market. However, when interest rates are low, in-vestors are more inclined to look for profits in the stock market, and thattrend can help lift share prices over the long term. In sum, for those read-ers interested in trading stock index options, index futures, and evenshares of large companies, this chapter is designed to help you by provid-ing a short course in economic analysis.

181



1. The ______________ has a corresponding futures contract that istraded at the Chicago Board of Trade (CBOT) and reflects one veryimportant aspect of many people’s lives: mortgage interest rates.

A. S&P 500.

B. OEX.

C. Ten-year note.

D. Crude oil.

2. In a typical situation, if interest rates go up, bond prices______________.

A. Go up.

B. Go down.

C. Stay the same.

D. Go either way—you can never really tell.

3. Bond prices and the stock market should ______________.

A. Go in the same direction.

B. Have an inverse relationship.

C. Go in opposite directions.

D. Have no relationship whatsoever.

4. If interest rates go sideways, stock prices will probably______________.

A. Rise.

B. Fall.

C. Go sideways.

D. Rise at first and then fall steadily.

5. There are periods when a/an ______________ occurs and stock pricesrise regardless of whether interest rates go up or down.

A. Inverse relationship.

B. Contrarian effect.

C. Divergence.

D. Momentum push.



6. If you see interest rates ______________ quickly, you don’t want to bea buyer of stocks.

A. Increasing.

B. Decreasing.

C. Increasing sharply and then falling off.

D. Decreasing slowly and then rising.

7. If you find that interest rates are ______________, being a buyer of stocks is a good idea because the stock market will have an upward bias.

A. Increasing.

B. Decreasing.

C. Stable or increasing.

D. Stable or decreasing.

MEDIA ASSIGNMENT

In order to better understand economic events, let’s begin tuning in to thehappenings in the bond market. One of the best ways to do this is to watchfinancial TV news before the start of stock trading. The bond marketopens and closes one hour before the stock market, so bonds begin trad-ing at 8:30 A.M. New York time. Furthermore, since many economic re-ports are released before the start of stock trading, the bond market willoften react to news first.

So, at 8:30 A.M. Eastern time (that’s 5:30 A.M. for West Coast traders),turn on CNBC and Bloomberg news and look for their reports that comefrom the Chicago Board of Trade (CBOT). At the time of this writing,CNBC offers live coverage of the start of trading on the CBOT every week-day morning one hour before the start of stock trading. The report sum-marizes the important daily economic news, forthcoming economicreports, and many other economic events (changes in oil prices, changesin interest rates, activity in the currency markets) that can have an impacton both stocks and bonds.

A Short Course in Economic Analyses 183


VOCABULARY LIST

SOLUTIONS

1. The ______________ has a corresponding futures contract that istraded at the Chicago Board of Trade (CBOT) and reflects one veryimportant aspect of many people’s lives: mortgage interest rates.

Answer: C—Ten-year note.

Discussion: The Treasury’s 10-year note has become a barometerfor the performance of the bond market. This bond is activelytraded and has a futures contract trading on the CBOT. As this fu-tures contract moves higher, it indicates that bond traders expectthat interest rates, which move opposite to the note, will fall goingforward. When the 10-year note futures contract falls, it is a signthat bond traders expect rates to rise. As rates rise and fall, thelong-term trend can impact many aspects of people’s lives, includ-ing mortgage rates.

2. In a typical situation, if interest rates go up, bond prices______________.

Answer: B—Go down.

Discussion: Bond prices move opposite to yields or rates. As bondprices fall, rates start moving higher.

3. Bond prices and the stock market should ______________.

Answer: A—Go in the same direction.

Discussion: In general, bond prices will move in the same directionas stock prices because falling interest rates often bode well for


Bond

Bond trader

Chicago Board of Trade (CBOT)

Correlation

Economist

Fed funds rate

Interest rate

Interest-bearing security

Inverse relationship

Maturity

Treasury bill

Treasury bond

Treasury note

Yield


both stocks and bonds. Rising interest rates are considered a nega-tive for stocks and bonds, so if rates experience a sudden movehigher, stocks and bonds tend to fall.

4. If interest rates go sideways, stock prices will probably______________.

Answer: A—Rise.

Discussion: Over the long haul, the path of least resistance forstocks is to move higher. So, if interest rates are not a factor, stockswill probably head higher.

5. There are periods when a/an ______________ occurs and stock pricesrise regardless of whether interest rates go up or down.

Answer: C—Divergence.

Discussion: Company earnings can continue to improve, pushingstock prices up, even if interest rates move higher. In this case, adivergence might occur, with stocks rising and bonds falling.

6. If you see interest rates ______________ quickly, you don’t want to bea buyer of stocks.

Answer: A—Increasing.

Discussion: Sudden spikes in interest rates often spook investors inthe stock market. Interest-bearing securities like bonds and savingsaccounts become more competitive compared to stocks. At the sametime, higher rates can make stock prices seem more expensive whenusing various valuation models.

7. If you find that interest rates are ______________, being a buyer of stocks is a good idea because the stock market will have an upward bias.

Answer: D—Stable or decreasing.

Discussion: Long-term periods of stable or falling interest rates often provide a favorable environment for higher stock prices.Lower rates make money more readily available for borrowing, investing, and building successful businesses. At the same time, interest-bearing investments become less attractive compared tostocks when rates fall.



MEDIA ASSIGNMENT

If you have been watching the early morning news reports from the finan-cial news services like CNBC and Bloomberg TV, you have probably no-ticed that trading in the bond market can become quite chaotic at times.Traders in the bond pits are continually trying to assess if interest ratesare going to move higher or lower, and then buying and selling based onthose expectations. In addition, since so many factors can influence inter-est rates (economic news, geopolitical unrest, oil prices, fluctuations inthe currency markets, stock prices, etc.), bond traders have a great deal ofinformation to digest.

Yet, while trading in the bond pits can turn frantic, the long-term rela-tionship between stock prices and bonds is fairly clear. Specifically, peri-ods of long-term bond strength and falling yields are generally bullish forstocks. Conversely, when interest rates are expected to move sharplyhigher, stocks have a tendency to move lower and experience greatervolatility. So changes in interest rates can be important to an optionstrader because longer-term trends can have an impact on both stockprices and overall levels of market volatility.


Bond: A debt obligation issued by a government (i.e., Treasury bond) orcorporation (i.e., corporate bond) that promises to pay its bondholdersperiodic interest at a fixed rate (the coupon) and to repay the principal ofthe loan at maturity (a specified future date). Bonds are usually issuedwith a par or face value of $1,000, representing the principal or amount ofmoney borrowed. The interest payment is stated on the face of the bondat issue.

Bond trader: An individual who works for a firm and buys and sellsbonds for clients. Bond traders work via computers or in the trading pitsof the Chicago Board of Trade.

Chicago Board of Trade (CBOT): The oldest commodity exchange inthe United States, established in 1886. The exchange lists agriculturalcommodity futures such as corn, oats, and soybeans, in addition to morerecent innovations such as financial futures.

Correlation: The relationship between the prices of two or more invest-ments. For instance, if X moves higher and B moves lower, X and B have anegative correlation. If two assets move in the same direction, they have apositive correlation.



Economist: Generally, a paid professional, often with a doctorate de-gree, who makes forecasts regarding the economy, interest rates, andeconomic activity.

Federal funds rate: The short-term interest rate controlled by the Fed-eral Reserve. The Federal Reserve will change this interest rate to stimu-late or cool down the economy.

Interest rate: The cost of borrowing money.

Interest-bearing security: A type of investment on which earnings bearinterest. Examples include money markets, certificates of deposit, andsavings accounts.

Inverse relationship: When the prices of two assets move opposite toone another.

Maturity: The date on which a bond’s principal is repaid to the investorand interest payments cease. Maturity is the number of years until the prin-cipal amount of a bond is due and payable by the issuer to its bondholders.

Treasury bill: Short-term government obligation that matures in 90 daysor less.

Treasury bond: Long-term government obligation that has a maturity ofup to 30 years.

Treasury note: Government obligation with 5 to 10 years until maturity.

Yield: Refers to the annual interest on a bond divided by the marketprice of that bond. The current yield is the actual income rate of returnas opposed to the coupon rate or the yield to maturity.



CHAPTER 16

Masteringthe

Market

SUMMARY

This chapter offers guidelines and suggestions to enhance a trader’s abilityto find profitable trades. It introduces several concepts including low risk,time requirements, and risk tolerance as well as casting a glance at riskprofiles and investment criteria. In order to become successful, tradersneed to figure out their own risk tolerance. Some of this has to do with theamount of capital available, and part has to do with time and stress.Nonetheless, every trade should consist of a high reward-to-risk ratio, re-sulting in a high probability of success.

Another part of successful trading has to do with money managementand setting up the appropriate system. Since emotions play a huge part intrading, traders are encouraged to avoid emotional trading. Fear and greedmove the markets, but good traders stick to their plans, using preset exitpoints. Exit strategies include time exits, profit exits, and loss exits. It isvery difficult to rid yourself of emotion when trading, but by understand-ing your exits and goals in advance, you can gain control of this detrimentto trading success.

Ultimately, you need to rely on your own knowledge and research tobecome a successful trader. Many who have relied on analyst commentsand advice from self-proclaimed gurus have ultimately found failure.There are many companies available to help you learn the rules of trading,including Optionetics, but ultimately it is up to you to do the researchnecessary and to enter and exit a trade correctly.

188



1. Name as many elements of a good investment as you can.

____________________________________________________________

____________________________________________________________

____________________________________________________________

____________________________________________________________

2. ______________ of any investment must take into account the fol-lowing elements: potential risk, potential reward, the probability ofsuccess, and how long the investment takes to make a return.

A. Limiting the risk.

B. The reward/risk ratio.

C. The delta neutrality.


3. Studying a risk profile can show you the potential increasing or de-creasing profit and loss of a trade relative to the underlying asset’s______________ over a specific period of time.

A. Volatility.

B. Volume.

C. Price.

D. Change in direction.

4. The best investments will have an opportunity for ______________with acceptable risk and a high probability of winning on a consis-tent basis.

A. High reward.

B. High volatility.

C. High liquidity.

D. Major market movement.

5. True or False: If you do not have the time to sit in front of a computerday in, day out, then your best investments will be day trades.

6. Your risk tolerance level is directly proportional to your______________.

A. Knowledge of the markets.

B. Computer availability.

Mastering the Market 189


C. Time requirements.

D. Available investment capital.

7. Name a few investment objectives.

____________________________________________________________

____________________________________________________________

MEDIA ASSIGNMENT

This chapter discusses risk tolerance and how to take emotion out of trad-ing. Having a set plan in advance for entering a trade is an important keyto lowering the part emotions play in our trading success. If traders takerisks that do not fit their risk tolerance, this will increase the emotions feltwhile trading. For this media assignment, take the time to write downyour risk tolerance and goals. This includes writing down the time youhave available to trade, the amount of capital that will be used to trade,and the profit goals you have set for your trading account. From the firsttrade, keep a trading journal that tracks not only the details of each trade,but the emotions and feelings you had as the trade progressed. You’ll beamazed at how much knowledge can be gleaned from reading the infor-mation found in a trading journal.

VOCABULARY LIST

SOLUTIONS

1. Name as many elements of a good investment as you can.

Answer: A good investment has low risk, a favorable risk profile, andhigh potential return. It meets your time constraints, risk tolerance


Bear market

Bull market

Capital

Capital gains

Interest income

Price/earnings (P/E) ratio


level, and investment criteria. It also meets your investment capitalconstraints and can be easily understood.

Discussion: This might seem like a lot to remember, but it all makessense. However, it is amazing how often new traders enter trades thathave horrible risk profiles or that don’t meet their time constraints.Initially, a new trader might need to go through each of these criteriato make sure a trade makes sense. After a while, this type of analysiswill become second nature, allowing a trader to make healthy profits,even while limiting risk.

2. ______________ of any investment must take into account the fol-lowing elements: potential risk, potential reward, the probability ofsuccess, and how long the investment takes to make a return.

Answer: B—The reward/risk ratio.

Discussion: All traders want to make as much profit as possible withthe capital used in their trades. By looking at a risk graph, many of theproblems with a trade can be uncovered. The reward/risk ratio can helpyou to determine the validity of a trade. However, you also need to un-derstand the probability of success and how long the reward will take toaccumulate, in addition to the basic risks and rewards possible.

3. Studying a risk profile can show you the potential increasing or de-creasing profit and loss of a trade relative to the underlying asset’s______________ over a specific period of time.

Answer: C—Price.

Discussion: A risk graph helps a trader view how the trade willchange in value given a move in the underlying security’s price. Ofcourse, there are other variables that can impact an option’s value,but the main component is the price of the underlying. It is easy tocreate a risk graph for simple strategies like long calls and long puts,but more complicated strategies might require the use of a computerprogram to view a correct risk graph.

4. The best investments will have an opportunity for ______________ withacceptable risk and a high probability of winning on a consistent basis.

Answer: A—High reward.

Discussion: It wouldn’t make sense for a trader to enter a trade thathas a loss potential of $5,000 when the maximum reward is just$1,000—that is, unless the probability of success is very high. This is thevery reason why we do not suggest naked option strategies, as thesetrades are extremely high risk and offer only a small reward. Though



they have a high probability of success in most cases, the one timewhen the trade goes against you can ruin your entire trading account.

5. True or False: If you do not have the time to sit in front of a computer day in, day out, then your best investments will be daytrades.

Answer: False.

Discussion: Day trading requires the attention of a trader on a minute-by-minute basis. This obviously wouldn’t be appropriate for a profes-sional who trades only occasionally. Before entering a trade, a tradershould look at the time needed to manage the trade. If this time com-mitment can’t be made, move on to a trade that can be handled in thetime you have available.

6. Your risk tolerance level is directly proportional to your______________.

Answer: D – Available investment capital.

Discussion: Though there are traders with large accounts who havevery low risk tolerances, normally the amount of capital available isthe largest determinant for a trader’s risk tolerance. When trading op-tions and individual stocks and futures, we should never use moneywe can’t afford to lose. Though we don’t plan on losing the money, ifwe can’t afford to lose it our emotions will take control of our trading.

7. Name a few investment objectives.

Answer: Interest income, tax-free government securities, capitalgains.

Discussion: Most traders view their main investing objective as mak-ing money. However, this has many meanings depending on the traderand his or her situation in life. Older individuals who are in retirementmight be concentrating mainly on income. Others might have taxproblems that require a large amount of money to be placed in govern-ment securities. Even traders looking for capital gains should have anunderstanding of how their trades will be impacted by taxes.

MEDIA ASSIGNMENT

Setting up a trading journal will be a real eye-opener. By reading backthrough your thoughts and feelings during a trade, you’ll learn a lot aboutyour state of mind and how controlled you may be by emotion. Not only



should you keep track of the details of a trade, but write down these feel-ings and review them consistently. By looking back on past trades, you cangain a better understanding of what you did right and what went wrong.


Bear market: A declining stock market over a prolonged period, usuallylasting at least six months and normally not more than 18 months. Usuallycaused by a conviction that a weak economy will produce depressed cor-porate profits. Also, a market in which prices of a certain group of securi-ties are falling or are expected to fall.

Bull market: A rising stock market over a prolonged period, usually last-ing at least six months and normally not more than 18 months. Usuallycaused by a conviction that a strong economy will produce increased cor-porate profits. Also, a market in which prices of a certain group of securi-ties are rising or are expected to rise.

Capital: The amount of money you have invested. When your investingobjective is capital preservation, your priority is to try not to lose anymoney. When your objective is capital growth, your priority is to try tomake your initial investment grow in value. Capital also refers to accumu-lated money or goods available for use in producing more money or goods.

Capital gains: The profit realized when a capital asset is sold for a higherprice than the purchase price. Your costs (when you buy) include thecommission you paid your broker and are deducted from the proceedswhen you sell.

Interest income: A type of income generated from interest-bearing secu-rities. The closer to retirement a person gets, the more important interestincome usually becomes. Government bonds and high-dividend-payingstocks provide this type of income.

Price-earnings (P/E) ratio: A tool for comparing the prices of differentcommon stocks by assessing how much the market is willing to pay fora share of each corporation’s earnings. It is calculated by dividing thecurrent market price of a stock by the earnings per share.



CHAPTER 17

How to SpotExplosive

Opportunities

SUMMARY

No two traders are exactly alike. Some, like stock investors, spend a lotof time studying individual companies, earnings reports, or financialstatements. Others, like currency traders, are more focused on economictrends, interest rates, and geopolitical events. Still others, such as fu-tures traders, are often more focused on charts and graphs. One methodis not better than any other, but you will find that many successfultraders specialize in one approach and become experts in that particularfield of study.

In this chapter, the reader is introduced to a wide variety of meth-ods—including fundamental, technical, and sentiment analysis—that canbe used to help locate profitable trading opportunities. Readers are alsoencouraged to use various media sources, including The Wall Street Jour-

nal, Investor’s Business Daily, and CNBC. In addition, a few informaltechniques—from using the contrarian approach to critiquing productsyou own, as well as some effective stock indicators—are explored.


1. What are the two general forms of market analysis?

1. _________________________________________________________

2. _________________________________________________________

194


2. ______________ analysis is primarily concerned with the underlyingfactors of supply and demand regarding a stock or commodity.

A. Fundamental.

B. Technical.

C. Sentiment.

3. Name some factors of fundamental analysis.

____________________________________________________________

____________________________________________________________

4. ______________ analysis is primarily concerned with statistics gener-ated by market activity and the resulting patterns and trends.

A. Fundamental.

B. Technical.

C. Sentiment.

5. Name two common tools of technical analysis.

1. _________________________________________________________

2. _________________________________________________________

6. ______________, probably the simplest and most widely used techni-cal tool, calculate price action over a specified period of time as amean or average.

A. Technical charts.

B. Moving averages.

C. Momentum indicators.

D. Contrarian approaches.

7. A ______________ utilizes price and volume statistics for predictingthe strength or weakness of a current market and any overbought oroversold conditions.

A. Technical chart.

B. Moving average.

C. Momentum indicator.

D. Contrarian approach.

How to Spot Explosive Opportunities 195


8. ______________ analysis is primarily concerned with the nature andimpact of crowd psychology on financial markets.

A. Fundamental.

B. Technical.

C. Sentiment.

9. Name some tools of sentiment analysis.

____________________________________________________________

____________________________________________________________

10. If you use ______________, you will be trading against the majorityview of the marketplace.

A. Charting techniques.

B. Moving averages.

C. Momentum indicators.

D. The contrarian approach.

11. True or False: Fundamental and technical analysis are mutually exclusive—traders should learn to use one or the other.

12. By studying the daily reactions of specific markets to ______________,you can begin to forecast which strategy can be used to make thelargest potential profit.

A. Interest rates.

B. Seasonal changes.

C. Government reports.


13. Name three ways you can spot potentially profitable investmentswhen shopping in a retail store.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

14. Name four ways to spot potential investments in your everyday life.

1. _________________________________________________________

2. _________________________________________________________



3. _________________________________________________________

4. _________________________________________________________

15. Data service providers can relay information in which three ways?

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

16. True or False: If you are going to sit in front of a computer all daylong, then you don’t really need real-time feeds.

17. ______________ was born from the Financial News Network (FNN),which was watched widely by the investment community.

A. CNN Business.

B. CNBC.

C. CBS.

D. FOX.

18. The best investments have ______________, which should be moni-tored over both a short and a long period of time.

A. Cheap options.

B. Low margin.

C. Momentum.

D. Low volatility.

19. An increase in a stock’s ______________ signals movement and agood opportunity for investment.

A. Price.

B. Volume.

C. Perceived risk.


20. The best investments have a reasonable ______________ relative tothe industry average.

A. Settle.

B. Yield and percent.

C. P/E.

D. Open interest.



21. Name six ways to spot potential profit-making stock opportunities.

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

4. _________________________________________________________

5. _________________________________________________________

6. _________________________________________________________

22. A low-priced market trades for less than ______________.

A. $10.

B. $20.

C. $30.

D. $50.

23. Why is it easier to make money on low-priced markets?

A. You can make a high return much faster.

B. You have less invested to lose.

C. You can play more stocks with less money.


24. The theory behind ______________, the basis of a mutual fund, is thata larger group of stocks will even out the chances of winning in thelong run.

A. Diversification.

B. A broad portfolio.

C. Both A and B.


25. Momentum investors are much more ______________ oriented thanmutual fund investors or money managers.

A. Short-term.

B. Long-term.

C. Volatility.

D. Profit.



26. A long-term indicator of momentum can be measured by looking for achange in price of a stock over the previous ______________.

A. 15 days.

B. 30 days.

C. 60 days.

D. 90 days.

E. Both A and B.

F. Both C and D.

27. If a stock has increased or decreased in price more than______________ since yesterday, this can be used to indicate a momentum investment.

A. 5 percent.

B. 10 percent.

C. 15 percent.

D. 20 percent.

28. If a stock trades less than ______________ shares daily, try to avoid itin short-term trading.

A. 100,000.

B. 300,000.

C. 500,000.

D. 1,000,000.

29. To apply the contrarian approach, look at the ______________ list tofind stocks that have made major moves down (50 percent or greater)and then look for a rebound.

A. Price Percentage Gainers.

B. Price Percentage Losers.

C. Volume Percentage Leaders.

D. Lifetime High and Low.

30. The blow-off bottom may have occurred when a stock is coming off anew ______________.

A. High price with high volume.

B. High price with low volume.

C. Low price with high volume.

D. Low price with low volume.



MEDIA ASSIGNMENT

The purpose of this media assignment is to find a reliable source forstock charts and indicators. There are a number of ways to do so. Anumber of web sites offer stock charting capabilities—including the Interactive Wall Street Journal, Bloomberg.com, Stockcharts.com,BigCharts.com, Optionetics.com, and a host of others. If you have abrokerage account, your firm might also offer real-time charts. Sub-scriptions to more advanced charting programs such as TradeStation,eSignal, and ProfitSource sometimes make sense for more activetraders who are looking for more sophisticated charting tools.

Whether using free trading capabilities online or using a more sophis-ticated software package, readers will want to begin reviewing charts on aregular basis. The first step is to select a small number of stocks that areactively traded. Look at the graphs over different time frames—daily,weekly, monthly. Understand that a trend can easily go from an uptrend toa downtrend depending on the time frame used in a chart. For example,what appears to be an uptrend on a daily chart could well be a downtrendon the monthly chart.

Next, apply indicators. Some important indicators have been dis-cussed throughout the chapter. Moving average convergence/divergence(MACD), Bollinger bands, and Elliott Wave analysis are examples of com-mon indicators that can be applied to charts using almost any softwareprogram or web-based charting tools. Look at a number of differentstocks and consider how various indicators can help identify turningpoints in different situations. In conclusion, readers should begin chartingstocks and applying indicators. Doing so provides a quick and easy way tosee the price action and technical trends of a stock or index.

VOCABULARY LIST


Bar chart

Blow-off bottom

Blow-off top

Capitulation

Contrarian

Data feed

Diversification

Fund manager

Fundamental analysis

Momentum

Moving average

Moving averageconvergence/divergence (MACD)

Mutual fund


SOLUTIONS

1. What are the two general forms of market analysis?

Answer: Fundamental analysis and technical analysis.

Discussion: Technical analysts rely heavily on charts, volume infor-mation, and trends. Fundamental analysts are more concerned withthe company or the industry. So, instead of looking at charts, the fun-damental analysts will spend more time with news releases, earningsreports, and other financial statements.

2. ______________ analysis is primarily concerned with the underlyingfactors of supply and demand regarding a stock or commodity.

Answer: B—Technical.

Discussion: Technical analysts will look at a chart along with volumeinformation to study the balance of supply and demand with respect toa specific stock or commodity. Technical analysis is based on the theorythat market prices display repetitive patterns that can be tracked andused to forecast future price movement.

3. Name some factors of fundamental analysis.

Answer: Products, customers, consumption, profit outlook, management strength, supply and demand with regard to outputs,and economic data.

Discussion: Fundamental analysts are concerned with the profitabil-ity of a company or industry. Often, the focus will be on hard factssuch as earnings, market share, and growth rates. The ultimate objec-tive is to determine whether the market price of the stock or commod-ity reflects its true value. If the market price is too high, then it wouldmake sense to sell short the investment. If the price in the market istoo low relative to the true value of the company or investment, the in-vestor may want to buy the asset or place a bullish options strategy.

4. ______________ analysis is primarily concerned with statistics gener-ated by market activity and the resulting patterns and trends.

Answer: B—Technical.


On balance volume (OBV)

Price-to-earnings ratio (P/E)

Real-time data

Seasonal patterns

Sentiment analysis

Technical analysis

Volume


Discussion: Technical analysts want to determine if the buying pres-sure or selling pressure is increasing relative to a specific stock or in-vestment. When buyers are gaining greater control, prices are likelyto rise. When sellers seize control, prices will fall. Statistics based onmarket activity along with patterns or trends can help determinerelative levels of buying and selling pressure.

5. Name two common tools of technical analysis.

Answer: Moving average and momentum indicator.

Discussion: Moving averages and momentum indicators areamong the more commonly used technical indicators, but there aremany more.

6. ______________, probably the simplest and most widely used techni-cal tool, calculate price action over a specified period of time as amean or average.

Answer: B—Moving averages.

Discussion: A moving average is the average of a given amount ofdata plotted on a stock chart using different time frames. For ex-ample, a 14-day average of closing prices is calculated by addingthe last 14 closes and dividing that number by 14. This simple toolis an easy way to see long-term trends and identify areas of supportor resistance.

7. A ______________ utilizes price and volume statistics for predictingthe strength or weakness of a current market and any overbought oroversold conditions.

Answer: C—Momentum indicator.

Discussion: Momentum trading is the practice of buying or selling aninvestment based on its price trend. For instance, if a stock has beenmoving higher on heavy volume for a considerable period of time, itis said to have strong upward momentum. Momentum traders will at-tempt to profit from this inertia by purchasing that stock during theupward move.

8. ______________ analysis is primarily concerned with the nature andimpact of crowd psychology on financial markets.

Answer: C—Sentiment.

Discussion: Sentiment analysis gauges investor sentiment by ana-lyzing the group consciousness of the marketplace, using various



market criteria that define the market’s “state of mind.” The goal is todetermine if investors, or “the crowd,” are bullish or bearish towardthe market. When studying market sentiment, the technical analystgenerally takes a contrarian approach. That is, if investors are pre-dominantly bullish, the analyst will be bearish (sell stocks). If, on theother hand, the crowd is bearish, the analyst will turn bullish (buystocks). Examples of indicators used in sentiment analysis includethe following: survey of newsletter writers, amount of margin debt,and mutual fund cash levels. The interpretation of these criteria, how-ever, is subjective. Luckily, market analysts do agree that certainmeasurements strongly suggest a predominantly bullish or bearishtone to the market, but sentiment analysis requires the combinationand interpretation of several measurements to reach a conclusion.

9. Name some tools of sentiment analysis.

Answer: Volatility Index (VIX), VXN, put/call ratios, advisor sentiment,confidence index, odd-lot short sales, mutual fund liquid assets ratio,short interest ratio, over-the-counter (OTC) relative volume, marketP/E ratio, and the Dow Jones Industrial Average dividend yield.

Discussion: A wide variety of sentiment indicators exists fortraders to explore. Two of the most popular include the VolatilityIndex (VIX) and put/call ratios. VIX reflects the implied volatilityand premium paid for SPX options and can rise dramatically duringperiods of uncertainty as investors scramble to hedge portfolioswith SPX puts. VIX tends to stay within a range for long periods ofmonths or years. When the VIX either exceeds or drops below thisrange, a mood of either pessimism (a high VIX) or optimism (a lowVIX) prevails.

Put/call ratios are used as a contrary indicator. Since calls makemoney when shares or indexes rise, they often represent bullish betson the part of investors. Conversely, puts increase in value when astock or index moves lower and, therefore, reflect bearish bets.Again, studying put/call ratios is an exercise in contrary thinking.Specifically, if most market participants (the crowd) are buying puts,it is a sign of negative sentiment and reason to turn bullish. Con-versely, a low put/call ratio is interpreted as a market negative sincethe crowd is excessively bullish, but probably wrong.

10. If you use ______________, you will be trading against the majorityview of the marketplace.

Answer: D—The contrarian approach.



Discussion: Contrarians bet against the crowd. The idea is that themajority of investors can’t be correct all of the time. When the major-ity view becomes too one-sided, it pays to bet against that view. Thus,the contrarian investor does the opposite of what the general consen-sus may be. Even though this may sound suicidal, time has repeatedlyproven this strategy’s wisdom.

11. True or False: Fundamental and technical analysis are mutually exclusive—traders should learn to use one or the other.

Answer: False.

Discussion: Many successful traders use a combination of technicaland fundamental analysis. In general terms, fundamental analysis isthe study of the company and technical analysis is the study of thestock price. As a trader, use what works for you.

12. By studying the daily reactions of specific markets to ______________,you can begin to forecast which strategy can be used to make thelargest potential profit.

Answer: D—All of the above (interest rates, seasonal changes, gov-ernment reports).

Discussion: Seasonal patterns, economic reports, and changes in in-terest rates are all factors to consider when studying the day-to-dayaction in the markets and developing options strategies. Ultimately,these are the factors that can trigger market volatility and end long-term trends.

13. Name three ways you can spot potentially profitable investmentswhen shopping in a retail store.

Answer:

1. What products are hot.

2. Which products have the most store shelf exposure.

3. Which products a clerk says are literally flying off the shelf.

Discussion: A simple way to look for investment opportunities is topay more attention to what is happening in your local area. Visitingretail stores, for example, and understanding what consumers arebuying can sometimes help uncover the next great investment.



14. Name four ways to spot potential investments in your everyday life.

Answer:

1. When you are driving around, take notice of companies and fran-chises where you get a good deal as to price, quality, and quantity.

2. Critique what you already own.

3. Ask your children what’s hot and what’s not.

4. Look around where you work for popular products and services.

Discussion: The day-to-day trends in your local area often reflectbroader trends throughout the economy. A question to ask is, “Who ismaking money and is there a way for me to profit as well?”

15. Data service providers can relay information in which three ways?

Answer: Real-time, delayed, and end-of-day.

Discussion: Many active traders use real-time quote services totrade. However, the cost of real-time quotes can be quite high. Alter-natively, traders can use delayed or end-of-day data, which are a bitslower but also less expensive.

16. True or False: If you are going to sit in front of a computer all daylong, then you don’t really need real-time feeds.

Answer: False.

Discussion: Day trading requires real-time quotes. Obviously, end-of-day data will not work because day trading attempts to capture pricemovements throughout the trading day. Delayed quotes will be tooslow. So for those traders who have decided to spend the day in frontof the computer, it makes sense to pay extra fees and get real-timedata feeds to be as competitive as possible.

17. ______________ was born from the Financial News Network (FNN),which was watched widely by the investment community.

Answer: B—CNBC.

Discussion: CNBC, now the most watched financial television newschannel, originated from the Financial News Network.

18. The best investments have ______________, which should be moni-tored over both a short and a long period of time.

Answer: C—Momentum.



Discussion: Prices move in trends. Momentum is a sign that a trendis healthy and is likely to have staying power. The best investmentswill therefore have positive momentum. The best shorting opportuni-ties will have downward momentum.

19. An increase in a stock’s ______________ signals movement and agood opportunity for investment.

Answer: B—Volume.

Discussion: Volume is the engine that makes an investment go. Ifthere is no volume behind an advance or decline, the trend is lesslikely to have staying power. Rising volume during a stock’s advanceis a possible sign of an attractive investment opportunity.

20. The best investments have a reasonable ______________ relative tothe industry average.

Answer: C—P/E.

Discussion: Valuations are an important consideration when look-ing for stock purchases. A high price-earnings (P/E) ratio is a signthat shares might be overvalued. Therefore, investors will want toensure that the stock’s P/E is reasonable compared to other compa-nies in the industry.

21. Name six ways to spot potential profit-making stock opportunities.

Answer:

1. Stocks with greatest percent rise in volume.

2. Stocks with an increase in price greater than 20 percent.

3. Stocks with a decrease in price greater than 20 percent.

4. Stocks with strong (buying)/weak (selling) earnings per share(EPS) growth.

5. Stocks with strong (buying)/weak (selling) relative strength.

6. Stocks making new 52-week highs or new 52-week lows.

Discussion: Technical-oriented traders rely heavily on price and vol-ume data. By studying patterns and relationships, these traders canincrease the odds of entering into winning trades. In that respect, thesix situations listed have stood the test of time.

22. A low-priced market trades for less than ______________.

Answer: B—$20.



Discussion: Stocks trading for less than $20 are considered low-priced for options trading purposes.

23. Why is it easier to make money on low-priced markets?

Answer: D—All of the above (make a high return faster, have lessinvested to lose, play more stocks with less money).

Discussion: An investor with a fixed amount of money to investcan generate better returns with low-priced stocks because (1)with lower-priced stocks each dollar move represents a larger per-centage move, (2) there is less invested to lose, and (3) you canparticipate in a greater number of different stocks with the sameamount of money.

24. The theory behind ______________, the basis of a mutual fund, is thata larger group of stocks will even out the chances of winning in thelong run.

Answer: C—Both A and B (diversification and a broad portfolio).

Discussion: A mutual fund is a large pool of money that invests indifferent types of securities. For example, a stock mutual fund holdsa portfolio of stocks. The benefits are that mutual funds allow in-vestors to spread their investments across a broad range of securitiesand therefore offer diversification.

25. Momentum investors are much more ______________ oriented thanmutual fund investors or money managers.

Answer: A—Short-term.

Discussion: Momentum investing is an aggressive short-term trad-ing style that is much more active than mutual fund investing. It involves much short-term buying and selling. In most cases, mutualfund investors buy shares and hold those shares over the longterm.

26. A long-term indicator of momentum can be measured by looking for achange in price of a stock over the previous ______________.

Answer: F—Both C and D (60 and 90 days).

Discussion: Technical analysts look at indicators over different timeframes, but 60 and 90 days are common for longer-term momentumindicators.



27. If a stock has increased or decreased in price more than______________ since yesterday, this can be used to indicate a mo-mentum investment.

Answer: D—20 percent.

Discussion: A rule of thumb when looking at daily price moves in astock is 20 percent. A gain of 20 percent or more suggests strongupward momentum. A decline of 20 percent or greater is a sign ofpowerful downside momentum.

28. If a stock trades less than ______________ shares daily, try to avoid itin short-term trading.

Answer: B—300,000.

Discussion: Illiquid and thinly traded stocks rarely make suitable in-vestments for short-term trading. Traders generally want to focus onstocks that see volume of 300,000 shares or more each day. Thegreater the volume, the better the stock for trading purposes.

29. To apply the contrarian approach, look at the ______________ list tofind stocks that have made major moves down (50 percent or greater)and then look for a rebound.

Answer: B—Price Percentage Losers.

Discussion: Use the Price Percentage Losers list to find stocks thathave fallen too far, too fast. If a stock is down 50 percent or more,there is a strong chance that it is due to rebound. This would be acontrarian approach because it is betting against the momentum ofthe stock.

30. The blow-off bottom may have occurred when a stock is coming off anew ______________.

Answer: C—Low price with high volume.

Discussion: Blow-off bottoms occur when a stock falls sharplyand investors panic. High volume is a sign that a blow-off has oc-curred. At that time, the stock will come off a low price and beginto move higher.

MEDIA ASSIGNMENT

The purpose of the latest media assignment is to find a source of stockcharts and perform some simple analysis. Recall that charts are really



windows for viewing the past price patterns of stocks, futures, and in-dexes. They can provide quick information and, although chart reading isgenerally considered the domain of technical analysts, almost all in-vestors use charts in one form or another. In addition, with today’s onlinecharting capabilities, applying indicators like moving averages is free,quick and simple. In the end, the reader should be able to:

• Access stock charts.• Create daily, weekly, and monthly charts for stocks like IBM, Exxon-

Mobil, and General Electric.• Create similar charts for the Dow Jones Industrial Average and the

S&P 500.• Apply moving averages and other indicators.• Draw trend lines as well as identify support and resistance areas.


Bar chart: Sometimes called the open-high-low-close (OHLC) chart, itgraphs the open, high, low, and settlement prices for a specific tradingsession over a given period of time.

Blow-off bottom: A sharp and dramatic fall in price accompanied byheavy trading volume. This often occurs when sellers have thrown inthe towel and the investment is due to head higher. It is also known ascapitulation.

Blow-off top: A steep and rapid increase in price followed by a steep andrapid drop in price. This is an indicator seen in charts and used in techni-cal analysis of stock price and market trends.

Capitulation: When investors en masse have completely given up hopeon an investment or market. Capitulation often occurs on heavy, panic-type selling, and is followed by a major advance in the investment or mar-ket. It is also known as a blow-off bottom.

Contrarian: An investor who continually bets against the crowd. Thecontrarian believes that the majority of investors are wrong about the di-rection of a market or investment at major turning points and that there-fore it pays to invest in a manner contrary to popular opinion.

Data feed: An electronic source of information that delivers quotes,news, and other research to a user’s computer. Traders rely on data feedsto deliver current prices, news, and charts.



Diversification: Spreading one’s assets across a wide variety of invest-ments within a portfolio to minimize the impact of any one security onoverall portfolio performance and to reduce the overall risk.

Fund manager: An individual responsible for the day-to-day investmentdecisions of a mutual fund. Fund managers often receive a performance-based incentive fee for handling the fund.

Fundamental analysis: A type of investment analysis that focuses oncompany-specific facts from financial statements like the balance sheetand annual reports. Earnings, sales, assets, management, products, andmarkets are also considered important. This type of analysis is used to de-termine whether a stock or group of stocks is overvalued or undervaluedrelative to the current market price.

Momentum: The tendency for the underlying asset to move in trends,higher or lower. As inertia takes hold, sometimes the move can begin toaccelerate. When this happens, the asset has strong price momentum.

Moving average: Added to stock charts, these indicators represent aver-age price over time. By averaging prices, the indicator can smooth or elim-inate the fluctuations in data and assist in identifying trends.

Moving average convergence/divergence (MACD): Created by GeraldAppel, MACD is a technical chart indicator based on moving averages. It ap-pears on charts as two lines. Crossovers of these two lines generate buy andsell trading signals. Alternatively, some traders plot MACD as a histogram.

Mutual fund: A pooled investment that holds a portfolio of securities. In-vestors can buy into the pool by purchasing shares. Mutual funds special-ize in different types of investments—growth stocks, conservative stocks,bonds, and so on.

On balance volume (OBV): A tool for viewing trends with respect tovolume. Developed by Joseph Granville, the indicator measures thebuying and selling pressure by looking at daily volume during a stock ormarket’s advance or decline. The math behind the indicator is straightfor-ward. If a stock finishes the day higher, the volume is added to the runningtotal; but if a stock finishes the day lower, the day’s volume is subtracted.Traders want to see OBV moving in the same direction (confirming the ex-isting direction).

Price-earnings (P/E) ratio: The price of a stock divided by its annualearnings. Price-to-earnings ratios are often used to determine if a stock isunder- or overvalued.

Real-time data: A source of information that is updated live and changesinstantaneously as prices change in the marketplace. Real-time data isusually provided for a fee.



Seasonal patterns: A consistent but short-lived rise or drop in marketactivity that occurs due to predictable changes in climate or calendar.

Sentiment analysis: The study of market psychology. The goal is to de-termine whether traders and investors are predominantly bullish or bear-ish toward the stock market. In general, analysts consider excessiveamounts of bullish sentiment to indicate short-term market tops. Highlevels of bearish sentiment often occur near market bottoms.

Technical analysis: A method of evaluating securities by analyzing statis-tics generated by market activity, such as past prices and volume. Techni-cal analysts do not attempt to measure a security’s intrinsic value.

Volume: The amount of trading activity associated with a given securityduring a period of time. Stock volume is measured in shares, and op-tions volume is based on number of contracts. In addition, volume canbe computed over different time frames, such as hours, days, weeks,months, or years.



CHAPTER 18

Toolsof theTrade

SUMMARY

This chapter discusses some of the tools available for the stock and op-tions trader, including charts, software programs, seminars, and tradingweb sites. Option traders need to develop a working knowledge of techni-cal, fundamental, and sentiment analysis, as well as understand how op-tions work. Although studying books can help traders become moreknowledgeable, it often takes time and practice to successfully learn themore subtle details of trading.

Although a new trader does not need to learn how to use every toolavailable, certain tools help flatten the learning curve. For example, theOptionetics web site has a number of free tools, including articles, charts,and option information. Other tools, like Optionetics Platinum, Profit-Source, and Advanced GET from eSignal, might also provide much neededhelp as you integrate options into your trading approach.

This chapter provides a brief example of how these tools can beused to find explosive trading opportunities. If you are new to the option trading game, then choose a few strategies that you feel willwork best for you and learn them inside and out. Too many traders get“analysis paralysis” when they try to use too many tools or technical indicators to find a trade.

212



1. True or False: A trader can never use too many tools to make tradingdecisions.

2. Name some of the tools that are available for the options trader.

____________________________________________________________

____________________________________________________________

3. True or False: A new trader should learn and implement everystrategy available.

4. Which of the following are chart types used by traders of stocks andoptions?

A. Line.

B. Bar.

C. Candlestick.


5. Name some of the tools the Optionetics Platinum site can provide fora trader.

____________________________________________________________

____________________________________________________________

MEDIA ASSIGNMENT

Take a free tour of the Optionetics web site, as well as the Platinum site.Optionetics.com is free of charge and has an abundance of articles andtools that can be accessed. Although Platinum has a fee, check out the 14-day free trial to access the potentials of this innovative site. By viewingthese two sites, a trader can start to work with data that can be systemati-cally gathered and used time and time again to make profits. Many tradershave a daily ritual of visiting the Optionetics web site to garner informa-tion about the options game from its staff of writers.

Tools of the Trade 213


VOCABULARY LIST

SOLUTIONS

1. True or False: A trader can never use too many tools to make tradingdecisions.

Answer: False.

Discussion: Though it is important to have various tools at your dis-posal, using too many can create confusion. When a trader becomesoverwhelmed with analysis tools, he or she may find it hard to decidewhich factors to follow, and that makes decision making tough.

2. Name some of the tools that are available for the options trader.

Answer: Internet sites, seminars, software programs, brokers andCNBC.

Discussion: Some tools are free and some have a cost. Though manytraders have become successful without paying for extra services andtools, using these tools can often cut the learning curve down sub-stantially. A carpenter could probably build a house with a hammerand handsaw, but it’s a lot easier to use more efficient tools.

3. True or False: A new trader should learn and implement everystrategy available.

Answer: False.

Discussion: Though a new trader should gain a basic understandingof the various strategies available, it is best to narrow trading choicesdown to a few strategies. This way a trader can gain specializedknowledge that will create consistent profits rather than trying to bea jack-of-all-trades.

4. Which of the following are chart types used by traders of stocksand options?

Answer: D—All of the above (line, bar, candlestick).

Discussion: Traders tend to form their own opinions of what chartswork best for them. Though line charts aren’t as popular as they once


Bar chart

Candlestick chart

Line chart

Put/call ratio

Volume


were, there still are traders who choose to use this simple charting tool.Bar charts and candlestick charts are the most popular styles used to-day because they paint a broader picture of the action of the stock.

5. Name some of the tools the Optionetics Platinum site can provide fora trader.

Answer: Stock charts, implied volatility charts, historic option data,option search tools, stock search tools and risk graphs.

Discussion: Though a trader does not need Platinum to become suc-cessful, it definitely helps speed up the process. Platinum offers toolsthat enable traders to search through millions of single option orcombination trades in just a matter of seconds. It also provides riskgraph analysis of your own personal trades, implied volatility rank-ings tailored to any option you choose, a trade selection matrix thatallows you to match trades with your market preferences, access toeasy paper trading through portfolio management with nightly e-mailof profit/loss performance, and historical back-testing capabilities onoptions going back more than two and a half years.

MEDIA ASSIGNMENT

There are many web sites and books available that will provide informa-tion about trading options and stocks. The Optionetics site is one ofthese and is free, including a discussion board where traders can shareideas and ask questions. By studying the information available on theOptionetics site, you’ll become familiar with a variety of tools for yourtrading arsenal.

Though it requires a fee, the Platinum site is a tool that many optionstraders say they simply cannot live without. The Platinum web site providesoption traders with a variety of powerful tools including:

• End-of-day options price, volume, and open interest data for indexes,stocks, and futures.

• End-of-day options Greeks for all puts and calls.• Option trade portfolio tracking and profit/loss calculations.• Implied and historical volatility information and charts.• Stock ranking tools.• Option search tools.• Extensive option analysis tools.• Complete back-testing of all trades and Platinum functions.



Option trades can be saved online and named along with a text de-scription. Trades can have any combination of stock options and longand short positions. Saved trades can be edited, copied, and sorted. Inaddition, end-of-day trade performance can be e-mailed each evening tothe trader. Option Greeks can be computed for the entire trade as wellas each leg, and online trade data can be transferred to other productslike Excel.

Platinum offers powerful visual features by allowing the graphical analy-sis of profit-and-loss risk caused by stock price changes, Greek delta varia-tions, and sensitivity to implied volatility changes. The trade probability ofprofit and most likely expected profit are also computed on a daily basis.

Some of the key volatility variables and options data that can be plottedinclude implied volatility (IV), statistical volatility (SV), stock price, volume,put/call ratio, option skew charts, and IV/SV charts for many different timeframe combinations.

The stock ranking and option search tools offer the user a high degreeof flexibility. Stocks can be ranked using up to 35 different ranking crite-ria. Many of the rankings are precomputed daily and put online for easyaccess. These rankings can be saved online in 10 user lists and can be ac-cessed in other Platinum tool sets. The option-searching feature cansearch a single stock’s option chain for option trades as well as traversemultiple stocks in lists simultaneously. Multiple option trading strategiescan also be searched using a variety of different search parameters.

Risk graphics of any trade can be computed for different criteria. Forback-testing tasks, the web site can operate at any trading date in the pasttwo and a half years. This includes all charts, option tables of data,searches, and risk graphics. In addition, users can enter trades in the pastand see how they have evolved to the present. As they enter these tradesthey have the ability to save them and close them out on their close date.

I encourage those of you new to Platinum to try out the free tour toget a deeper understanding of the software’s capabilities. If you are a newuser and there is a feature you are confused about, be sure to utilize thecontext help facility, which is available on virtually every screen in thesystem. The Platinum site makes it easy to integrate these powerful toolsinto your own trading.


Bar chart: A chart that graphs the high, low, and settlement prices for a spe-cific trading session over a given period of time. Also called an OHLC chart.

Candlestick chart: A type of charting that uses a body and shadow foreach trading period. Like a bar chart, the open, close, high, and low pricesare found in each candlestick.



Line chart: A type of chart that uses only the close of each period. Thistakes out much of the noise found in the daily movement, but these detailsare often important to a technical trader.

Put/call ratio: The amount of puts traded on a security compared to theamount of calls. This is a contrarian indicator that helps traders find possi-ble tops and bottoms for a stock or index.

Volume: The amount of shares bought and sold on a stock exchange.



CHAPTER 19

FinalSummary

SUMMARY

Traders are constantly bombarded with a multitude of ways to trade stocksand options, leaving many traders unsure of where to start. Optioneticsteaches that a systematic approach, used with discipline, can create solidtrading profits. Though options traders can benefit from directional strate-gies, traders can also profit without the need to predict market directionusing delta neutral strategies.

In the beginning, new traders need to focus on learning just a couple ofthe strategies and master them. As your experience increases, along withyour success rate, you then can add a wider variety of strategies. Tradersneed to use proper risk management and money management, allowing lim-ited mistakes to be made. Make sure you use only money that you can affordto lose. In addition, you should not invest all your trading capital at one time.

This chapter provides a trading matrix that can be used to narrowdown the appropriate strategies given the level of implied volatility and atrader’s view for the stock. Options provide a number of strategies that canbe implemented in any type of market environment. However, it is up tothe trader to decide what strategies fit the given market scenario.

This chapter also discusses the investing philosophies of some of themost successful investors throughout investing history. Though these in-vestors looked more long-term for their trades, we can learn from their dis-ciplined approaches and viewpoints. Diversification was a common theme,as was having a thorough understanding of the investment. The key to suc-cess in trading stocks or options is to take emotion out of the equation.

218


This may be tough to do; however, by choosing profit and loss exits aheadof time, emotions can be pushed aside when this selling point is reached.


1. How much time should a new trader take paper trading a new strategy?

A. None—just jump right in with real money.

B. One trade.

C. One week.

D. At least three months.

2. Using ______________, traders have the opportunity to maximizeprofits and make consistent returns without the need to predictmarket direction.

A. Vertical spreads.

B. Delta neutral strategies.

C. Covered writes.

D. Ratio spreads.

3. Ultimately, only ______________ can take care of your money.

A. Your broker.

B. A financial guru.

C. You.

D. The IRS.

4. A directional trader has to be right about which of the following assessments?

A. Direction.

B. Magnitude of the move.

C. Time frame of the move.


5. True or False: Understanding volatility is one of the most importantcomponents of becoming a successful options trader.

6. Which one of the following strategies would not fit a scenario of lowvolatility with a bearish bias?

A. Buy put.

B. Bear put spread.

Final Summary 219


C. Buy ITM call.

D. Bull put spread.

7. ______________ is merely another way of expressing a driving needfor perfectionism.

A. Fear.

B. Lying to yourself.

C. Greed.

D. Poverty consciousness.

8. Which of the following is/are key for a trader to become successfultrading options?

A. A bargain-hunting instinct with the ability to identify undervaluedand overvalued options.

B. A sound and well-designed game plan that provides consistentaction over time and that prospers in all market conditions.

C. The discipline to follow the game plan.


9. What are the three questions every trader should ask before gettinginto a trade?

1. _________________________________________________________

2. _________________________________________________________

3. _________________________________________________________

MEDIA ASSIGNMENT

By now you should have a good understanding of what is needed to be-come a successful options trader. Take the time to write down thethings you have learned from this book and review these discoveriesfrom time to time. In addition, choose a few strategies that have caughtyour interest and start paper trading them. If you haven’t already doneso, start a trading journal to track the details of each trade, as well as todocument your thoughts along the way. Hopefully, this book has pro-vided some tangible insights about how to trade options successfully.Now it’s up to you to take these ideas and integrate them into your trad-ing plan.



SOLUTIONS

1. How much time should a new trader take paper trading a new strategy?

Answer: D—At least three months.

Discussion: Each trader will have his or her own time frame that isneeded to paper trade a new strategy. However, most traders shouldspend at least three months testing a new strategy. A longer amount oftime might be necessary if a strong understanding of the strategy is notachieved within three months. Nonetheless, eventually a trader needsto bite the bullet and test these strategies with real money. The key is tostart small and build up the amount you trade as your expertise grows.

2. Using ______________, traders have the opportunity to maximizeprofits and make consistent returns without the need to predictmarket direction.

Answer: B—Delta neutral strategies.

Discussion: Delta neutral strategies help take some of the guess-work out of trading options. Trading directional strategies can beprofitable, but the move must be large enough in the predicted direc-tion and within a certain time period. The key to long-term success inthe options game is to make consistent returns. It’s nice to hit a homerun now and then, but the consistent base hitter tends to have thebest results all told. Delta neutral trading enables investors to makemoney regardless of market direction—a revolutionary approach intoday’s volatile markets.

3. Ultimately, only ______________ can take care of your money.

Answer: C—You.

Discussion: Too many traders have found out that listening solely toa broker or financial guru is detrimental to their trading accounts’health. Though we can learn from brokers and various web sites andnewsletters, we are the only ones who really care about the successof our trading accounts. It might seem easier to rely on stock and op-tion selections from someone else, but when things go wrong, youneed to take responsibility and learn from your mistakes.

4. A directional trader has to be right about which of the followingassessments?

Answer: D—All of the above (direction, magnitude of the move, timeframe of the move).

Discussion: All three of these assessments need to be right in orderfor a directional trader to see profits. This doesn’t mean directional

Final Summary 221


trading can’t be profitable, but delta neutral trades are often easierto profit from because they do not need to see a certain market di-rection. Ultimately, it is the disciplined traders who are successful,regardless of what strategies they implement.

5. True or False: Understanding volatility is one of the most importantcomponents of becoming a successful options trader.

Answer: True.

Discussion: Too many new traders believe that their experience in thestock market will transfer over to success in trading options. Though itis important to have a basic understanding of the stock market, includ-ing technical and fundamental analysis, options do have additionalconcepts that need to be learned. Mainly, if we do not trade optionswith the appropriate implied volatility for the given strategy, losses canoccur even when our analysis of the underlying stock is correct.

6. Which one of the following strategies would not fit a scenario of lowvolatility with a bearish bias?

Answer: D—Bull put spread.

Discussion: A bull put spread is a credit strategy that is bullish in na-ture. When volatility is low, we normally want to be the buyer of op-tions. Though the bull put spread uses puts, it is a bullish strategy anddoes not fit a low-volatility market with a bearish bias. Any tradeshould be viewed in a risk graph before it is entered to get an idea ofwhat risks there are to the trade and if your expectations will createan appropriate profit.

7. ______________ is merely another way of expressing a driving needfor perfectionism.

Answer: C—Greed.

Discussion: Perfection has become a driving standard for many peo-ple, given the high expectations and competitive nature of today’s so-ciety. However, perfection is impossible to achieve in the tradinggame. The successful trader is disciplined and unafraid to take a losswhen needed or to take a profit even if it isn’t at the apex of the possi-ble gain. Option traders are going to have losses, even when they doeverything right. However, it is the disciplined trader who is able toget rid of the emotions of greed and fear who is successful.

8. Which of the following is/are key for a trader to become successfultrading options?

Answer: D—All of the above (a bargain-hunting instinct with theability to identify undervalued and overvalued options, a sound and



well-designed game plan that provides consistent action over timeand that prospers in all market conditions, and the discipline to followthe game plan).

Discussion: All three of these elements are key for traders if they wantto be successful. As a trader, you need to understand if an option is un-der- or overvalued in order to enter the best reward/risk trades. Youalso need to have a plan set up in advance, so that emotion does nothinder your decision making process. Finally, try to develop tradingdiscipline so that you have the courage to stick to your trading plan.

9. What are the three questions every trader should ask before gettinginto a trade?

Answer:

1. What is the market entry?

2. What is the profit exit?

3. What is the loss exit?

Discussion: Before you enter any trade, you should have a set entrypoint and exit based on profit and loss. Just like an airline flight atten-dant who tells passengers where the exits are before takeoff, a tradershould have a similar plan. Emotion is the major obstacle for bothnew and experienced traders, and having preset entry and exit pointshelps alleviate a large amount of emotion-based uncertainty.

FINAL WORD

Regardless of whether you decide to trade stocks, futures, options, or allthree, there are certain characteristics that all successful traders pos-sess. These attributes are very important for any trader to acquire if heor she wants to make it in this business over the long haul and continu-ally bring in profits.

The first characteristic and probably the most important is discipline.It is absolutely paramount that a trader has full control of his or her emo-tional state of mind to be successful at trading. Discipline allows the traderto be more objective and enhances the capacity to identify an opportunity.In addition, it provides the trader with the necessary confidence to refrainfrom taking action because many times traders feel they must always be in-volved in the markets. Knowing when to stay out is as important as know-ing when to take advantage of an opportunity. This all requires self-control,discipline, and the courage to pull the trigger at the appropriate time.

Next, a good trader needs to be persistent. This means a trader should

Final Summary 223


never take losses personally. Instead a determined trader will attempt tolearn from prior mistakes and persist in developing successful trades.This is a fine line, however, because although it is important to learn frommistakes and admit when you are wrong, it is also important to knowwhen not to quit. This type of mentality is also vital when searching for atrading methodology best suited to your style.

Patience is another critical attribute. Many times the trader must waitfor the right opportunity versus acting on the wrong ones. Since there aremany incorrect actions one can take in the market, it is important to waitfor the right opportunities. Many traders are fearful of missing somethingif they are not always in the market. The patient trader has the confidenceto wait for the correct opportunity to present itself.

Another key attribute a good trader must possess is the ability tothink independently. Most successful people in any business are indepen-dent thinkers. This often requires going against the crowd and establish-ing a point of view different from the norm. This can be uncomfortable formany people. As a trader, it is important to filter out the opinions offriends, associates, and brokers. Trading strategies and the actual execu-tion of trades involve a singleness of purpose and firm resolve. That iswhy it is so essential for a good trader to develop independent thinkingand avoid the herd mentality.

Contrary thinking is also an important characteristic. People have ahard time going against the crowd. Cultivating the art of contrary think-ing allows the trader to take actions that oppose the majority. This is im-portant because (generally) the majority is wrong and public losses arecommonplace. So it is essential to be able to evaluate what the crowd isthinking and have the courage to take an independent approach to themarket. Contrary opinion will also help the trader avoid being trappedwhen panic takes hold of a market. In this way, a good trader will be ableto take advantage of the emotional extremes in the market and profitfrom them.

Good traders must also be truthful with themselves and accuratelyassess their strengths and weaknesses. This is rarely easy and is spo-radically done by most traders. However, recognizing the truth is a keyrequirement for achieving success as a trader. A good trader must con-tinually engage in a process of self-reflection. Learning to take an hon-est inventory of your own motivations, priorities, and actions willenable you to accentuate your strengths and work on the weaknessesthat make you vulnerable in the market.

A dedicated trader must be able to act quickly and flawlessly executehis or her trading plan. There is a clear and important distinction betweendeveloping a sense of urgency and acting impulsively. A good trader wantsto constantly pay attention and be poised to take action without being too



spontaneous or whimsical. The market can move very fast at times, so it isimportant not to get overwhelmed by indecision and fear. Otherwise thetrader gets a sense of paralysis and no action will be taken. It is notenough to be in the right place at the right time; you must also be able totake correct action.

These key attributes have to be part of a trader’s skill set for thetrader to be successful over the long term. I encourage you to review thepreceding paragraphs as your trading career progresses. Continually try-ing to improve in all these areas is a lifelong commitment. Your efforts aresure to be well rewarded in the form of future trading profits.

Good luck and great trading!

GEORGE A. FONTANILLS

Miami Beach, Florida

December 2004

Final Summary 225


the option course with exercise.pdf

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